Series on tax: Part 2 – distortions and burden

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Over at Rates Blog I have put up part 2 or a 6 part series on tax (it was going to be 5 but I’ve extended it.  In part 1 we asked “why do we tax“.  In part 2 we are digging deeper into the costs of taxation.

We focus on two specific issues, the way taxes distort behaviour, and the idea of where the burden of tax falls.  As we explained in the first article these issues are really really difficult to actually work out – and the purpose of the second argument is just to give a “flavour” to the argument.  In honesty, if you wanted to figure out the true burden and distortions you’ll have to get yourselve a series of these CGE modeling economists armed with other economists who focus on normative judgments.

Last time I promised to discuss tax systmes that seem idea, that we don’t use.  And why we don’t.  Well, that is now the next article.

Also, thanks to Agnitio who helped me clear up this article.  It is a fairly wonkish one, and he came in at the last minute and helped me clarify what the hang I was doing ;)

“Rebalancing” and other morality plays

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On my list of future things to post on I had this post – which was intended to be a “bitch about rebalancing and targeting house prices for financial stability”.

Ever since the crisis erupted I have, especially privately, called the “rebalancing” argument one of the most pathetic quasi-economic arguments imaginable.  I found it difficult when a large section of the New Zealand economics community started using it, because apart from being a close to meaningless metaphor it also has the disadvantage of misleading people – confusing macroeconomic policy ideas with “compositional” issues, leading to the typical “fallacy of composition arguments” which lead to bad bad policy.

It is with this in mind that a good friend of mine sent me this BERL report on rebalancing the macroeconomy.  And it is with the recognition that it is not just BERL – but a large section of New Zealand’s economists – who make this argument that I aim to discuss why the focus on discussing rebalancing is bad economics.

Rebalancing is a term used to hide value judgments and sell a moral argument about the “right structure of the economy” – it is not an objective way of facing the trade-offs of policy choices, and as a result is it a bastardisation of what economists should be describing for the public.

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Experience may not improve judgement

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We’ve all met hardened cynics in our professional lives. Those people who think the worst of those they meet at every turn because they’ve been burned so many times. They give nobody the benefit of the doubt and look down on new staff for their hopelessly naivety and gullibility. The question posed by a group of researchers in the latest EJ is whether judges are similarly afflicted by experience.

They take a panel of UK Competition Commission decisions from 1970–2003 and evaluate the effect of the chairman’s experience on the probability of an adverse finding. Using a panel of that size allows them to control for various effects such as the chairman’s age.

Using a unique data set of companies investigated under UK competition law, we find very strong experience effects for chairmen of investigation panels, estimated from the increase in experience of individual chairman. Probit and IV probit regressions indicate that replacing an inexperienced chairman with one of average experience increases the probability of a ‘guilty’ outcome by approximately 30% and, after chairing around 30 cases, a chairman is predicted to find almost every case guilty.

Housing fuelled consumption boom?

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In the EJ:

There is strong evidence that house prices and consumption are synchronised. There is, however, disagreement over the causes of this link. This study examines if there is a wealth effect of house prices on consumption. Using a household-level panel data set with information about house ownership, income, wealth and demographics for a large sample of the Danish population in the period 1987–96, we model the dependence of the growth rate of total household expenditure with unanticipated innovations to house prices. Controlling for factors related to competing explanations, we find little evidence of a housing wealth effect.

Careful where we lay the blame

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Brian Fallow writing in his normal clear and intelligent manner has come out discussing the government budget.  As he says, a slump is not the time for “austerity” in terms of cutting back the size of government, and we should allow temporary deficits to help ease the blow – the point of automatic stabilisers is that they help out those that are struggling the most during a protracted slowdown.  Furthermore, I agree that the low level of long-term government bond rates does imply that government should be shifting investment forward now – something they seemed willing to do in 2009 but have moved away from since.

But, I have to slightly take issue with this:

Especially so since the Reserve Bank yesterday voiced concern at signs that the improvement in household saving rates may be stalling and that household debt is rising from a level already high relative to incomes.

The Government also argues that by running a tight fiscal policy it allows the bank to keep monetary policy looser than it otherwise could – lowering pressure on interest rates and the dollar.

However, as the bank reminded us yesterday, that silver lining comes with an increasingly ominous cloud in the form of rampant house price inflation, most notably in Auckland.

With the dollar as high as it is, the bank is reluctant to raise interest rates.

With the supply side of the housing market, especially in Auckland, unlikely to relieve the pressure on prices for years, and with gruesome examples in the Northern Hemisphere of what happens to an economy when a housing bubble bursts, at some point the bank is going to have to crush the demand side by raising interest rates.

If that coincides with fiscal contraction from a debt-obsessed Government, the effects could be unpleasant.

I don’t like where this logic is starting to go.  The RBNZ is responsible for “aggregate demand” in the economy.  If this is too low, then the RBNZ has set monetary conditions too tight, it is their fault.  Sure they may say it is not, some may say I am being unfair saying this … but if there is anything history has shown us, whenever we try to say “this time is different” with regards to a demand shortfall we usually end up coming back to blaming the central bank.

Relatively high debt levels and high house prices are not a monetary policy or demand issue.  They are an issue of financial stability, an issue of economic structure.  Yes, they create risks and can have negative welfare consequences.  Yes, competition, fiscal, and financial stability policy needs to account for them.  But monetary policy needs to take fiscal, competition, and financial stability policy AS GIVEN and then focus on “demand” from there.

Not dealing with demand because of concerns about these issues isn’t prudent, it is policy failure.  Blatant policy failure.  If you don’t believe me, ask someone who is both smarter and more articulate than me such as Nick Rowe.

Now, if the government remains on course and the RBNZ tightens monetary conditions to “fight the housing market” while it expects inflation to be low and unemployment high, they are explicitly violating their mandate and best practice of a central bank.  It is as simple as that.  I’m happy saying this out loud because they would not do that, they know these things, and will continue attempting to set monetary policy at the right level to deal with demand issues (as represented by their forecasts for inflation and unemployment over the next two years).  But given that the RBNZ does this appropriately, the government deficit does not matter outside of its impact on the composition of the economy.

If we want to criticise government policy during the recession, do it in terms of investment (it would have been a good time to move a bit more investment forward), and social policy related things.

Note:  If we believe that the response to interest rate changes will be very small, that in some sense investment demand is very “inelastic” then we can make a claim for government investment – we just need to be very clear on that AND we need to ask why in that case we still have a positive cash rate.  Remember, government investment here also works by driving up the “natural” interest rate … so through the same logic it will lead to a higher real exchange rate and higher government borrowing … unless the “cumulative impact” of rising demand pushing activity towards potential outweighs that.  And if we are using that “cumulative impact” argument for government spending then it also holds for a cut in domestic interest rates, just with a lower real exchange rate and compositionally more private sector activity.  So protip:  we can’t complain the exchange rate is too high and that government spending is too low at the same time!

Update:  Also after today’s unemployment and employment numbers I think people should be willing to rethink whether they think there is a “demand” issue in NZ going forward … ;)

Who can we really believe?

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In a great interview, Dani Rodrik asks why

You get trade theorists who have built their entire careers on “anomalous” results who are at the same time the greatest defenders of free trade. …the minds of analytically sophisticated [economists] turn into mush when they are forced to take seriously the policy implications of their own models.

This is something that we all encounter constantly: people who ‘should know better’ advocating a policy that seems poorly designed. Why might it happen? It is common to resort to explanations that involve mendacity and duplicity, but they are as unsatisfying as they are implausible. It is highly unlikely that everybody we disagree with lies, while we ourselves are paragons of virtue and transparency. In fact, Rodrik identifies the most convincing explanation later in his essay: “There are powerful forces having to do with the sociology of the profession and the socialization process that tend to push economists to think alike.” Exactly, and none of us are immune to it.

Psychologists have demonstrated that logic tends to be used only as a post-hoc rationalisation of our intuitive response to ideas. When economists respond to a new policy idea they will tend to draw on their toolbox of ideas to defend whatever intuitive response they have to it. Those intuitions are greatly influenced by our social identity, which develops to align the intuitions of social groups. As Rodrik points out, the prevailing view of economists at the time that free trade and unfettered markets are a good thing was far more influential than the, more ambiguous, implications of current research. Of course, economists had a vast stock of reasons why governments might fail and could mount a very convincing justification for their free market intuitions. It takes other experts with different intuitions to cut through that fog as they justify their own beliefs.

What does this mean for the way we listen to experts and interpret their opinions? As Tyler Cowen says, “Evaluate literatures not individual papers.” Individuals are incredibly unreliable for the reasons outlined above. The aggregated view of a range of people with different intuitions is much likelier to represent the truth. No individual is an oracle and following the teachings of a few people is likely to lead us astray. That is why economists tend to be sceptical of ‘surgical policy interventions’ and far more trusting of markets than most people. Of course, in saying that I’m probably exhibiting my groupish bias in favour of market solutions!