Thou Shalt Not Beggar Thy Neighbour

Suppose that the proposed changes in the Social Security Contribution are a success, namely, that prices go down, investment goes up, unemployment goes down and global external competitiveness increases, all by large margins. Portugal would provide a new view for economic policy for the whole world, and fully confirm the theoretical approaches developed in the last decade or so. We would have visits from economists and politicians to study locally the phenomenon. But... If that happens, what would stop Spain from taking the same measure? And then France, and then Italy... Maybe the final outcome would be some sort of European wage union, replicating the euro, which was created, among other things, to stop competitive devaluations... The fact that no one is really worried about this form of competitive devaluation, however, may be a good indicator of its potential.

austerity, policy choices and demonstration

The announcement of a policy increasing the social security contribution of workers with a reduction in employers' contribution was the spark that lead to a strong street demonstration Saturday 15th. The demonstration was already called for but the announcement of the new measures did put people on the street.

The complain was obviously the perceived unfairness of shifting money from workers to employers, and more broadly the austerity imposed by the financial rescue plan. Still, this simple view may be misleading. The demonstration was shared by several cities in Portugal, people interviewed were basically expressing the concern about the road taken by the Government with this specific policy. In the end, despite some fear it was a peaceful demonstration, gathering people from different ages and political views. More tense images from the demonstration walking by the IMF delegation in Lisboa can be somewhat misleading about the general feeling of the population, at least for now.

We need and should discuss the direct economic implications of this policy (see the posts of Susana Peralta and Francesco Franco on this).  Still, there is another sort of impact and in a sense a deeper one that may have implications for economic activity.

The demonstration was a clear call for the government to review the latest measure on social security contributions. Whatever the end result, whether the policy measure will be carried out as proposed, or modified or even dropped, there is the risk of this week events having an impact on the ability to introduced further reforms in the public sector, in the labour market, in the housing market, etc...

The necessary goodwill among social partners has been damaged to some extent, and there will be need to rebuilt trust between the government and the social partners, and between government and the population at large.

Also the impact on effort and willingness of people to move forward may be affected. Long term solutions for the portuguese economy have to involve development of new products and services, provide services and goods with high quality, and so on. But the commitment of workers to make more effort to develop new products, to increase productivity in current tasks, and even to smile when providing a service to the tourist may be at risk. Thus, the discussion on productivity gains needs to regain a central role - how does a policy proposal contribute to increase productivity? how fast and how much?

A suggestion: increased progressivity

Ricardo Reis has suggested increasing the progressivity of the personal income tax as a means to raise more revenue and tackle the budget problem (may be read here, in Portuguese). There are several good reasons for the government to take this suggestion seriously. As Ricardo himself writes, the labor supply elasticity of top income earners with respect to  marginal tax rates is empirically lower than what is generally accepted in the political debate. This recent paper surveys the empirical literature on the estimation of tax elasticities and concludes that there is room to increase tax revenue by increasing the marginal tax rates of top income earners.

The  elasticity may stem from four types of behavioral responses to tax rates which lead to a change in reported income following a tax reform. The first one is decreasing labor supply, the second is tax evasion and the third one is income shifting (i.e., shifting part of one's taxable income to corporate income tax by means of more or less complicated, albeit legal, administrative and accounting procedures). The fourth one is a bargaining channel - top income earners usually have decision power over the wages they offer themselves and may simply allocate a greater share of firms' profits to their own compensation packages. Their incentive to do so is obviously lower if they are subject to higher marginal tax rates.

The first channel is the only one which entails an efficiency cost. The second may be tackled by improving the tax administration competences and monitoring capacities. The third channel, in turn, implies that fiscal revenue will increase elsewhere, e.g., in corporate income tax (although in principle the total fiscal revenue decreases). Hence, if anything, the elasticities of reported income with respect to the income tax rate, which range between 0.12 and 0.4 are an upper bound on the actual efficiency cost of taxation. For instance, an elasticity of taxable income of 0.4 implies that a 1% increase in the tax rate decreases taxable income by 40%. Let's make this clear: an increase in the tax rate will only decrease tax revenue if this elasticity is higher than 1 - that is far from being the case.

The fourth channel is particularly appealing in the actual context of increasing inequality and economic crisis, because it entails a zero-sum transfer of resources from bottom to top income earners. This other paper suggests that this latter is the most important determinant of the elasticity of taxable income of top income earners, building a case for high marginal taxes on top incomes as a means to decrease the incentive of managers to offer themselves a larger share of the pie.

How does Portugal compare to the remaining OECD countries in the way it taxes top income earners? The Figure taken from this paper shows that it scores relatively low in this regard.

Source: Piketty, Saez and Stantcheva, "Optimal Taxation of Top Labor Incomes: a Tale of Three Elasticities", CEPR 2011.

And what about the efficiency consequences of increasing it? They are likely to be limited, as discussed above, and because there is no apparent link between changes in marginal tax rates of top income earners and GDP growth.

Source: Piketty, Saez and Stantcheva, "Optimal Taxation of Top Labor Incomes: a Tale of Three Elasticities", CEPR 2011.

With the current erosion in the political consensus around the rescue package in Portugal, this is interesting food for thought.

Social Security Contributions, wages and employment

The government's announcement of a change in Social Security Contributions raised a lot of fuss about a transfer from employers to employees. To recall, the government has announced an increase in employee's social security contributions of 7 pp from 11 to 18% and a decrease in employer's SSC of 5.75 pp from 23.75 to 18%. Almost everyone in the country seems to take it for granted that this will lead nominal net (of SSC) wages to decrease by 7 pp. A usual textbook argument about perfectly competitive markets would simply state that the legal incidence of the tax does not matter, and hence we should only worry about the overall increase in 1.25 pp. However, labor markets are far from being competitive and do not behave as in the simple textbook argument. A quick literature review suggests the following.

1. The effects of SSC are very much context specific because they are not, strictly speaking, taxes (they entitle the workers to future income) and the precise way in which contributions are tied to benefits matters a lot for the behavioral responses.
2. The overall tax increase is likely to be borne mostly by employees (i.e., net wages are expected to decrease by around half of the total SSC increase). Here is a reference on this.   Importantly, the shifting of the tax burden towards employees seems to be stronger when the perceived link between SSC and pension benefits is stronger.
3. Estimating the impact of the nominal (or legal) sharing of the tax burden between employers and employees is difficult because of identification issues which are common to all the empirical literature on labor supply responses to tax changes. It is hard to disentangle changes in marginal and/or average tax rates on reported income from other non-tax factors such as unmeasured effort on the job, career choices, tax avoidance, and tax evasion. Exploiting a reform on SSC implemented in Greece in 92, which in a nutshell amounted to an increase in SSC of both employers and employees for high-wage earners, Emmanuel Saez and co-authors conclude the following. Firstly, labor supply is inelastic with respect to social security contributions. Secondly, the legal incidence of the SSC does matter, in the sense that the workers' net wage decreases following the increase in the employee SSC and the employers pay a higher gross wage following the increase in their own part of the SSC. While the authors themselves ask for caution in the generalization of their results to other contexts, this is still the best contribution that I know for the current debate.

 I do not resist to end with a citation of the paper cited above: "our results imply that employer vs. employee pay-roll tax cuts are likely to be sticky at least in the medium term. Under such nonstandard stickiness, reducing employer payroll taxes would increase profits while not affecting net wages, a desirable outcome when businesses face liquidity constraints to grow but an undesirable outcome when businesses are hoarding cash and reluctant to invest. In contrast, reducing employee payroll taxes would increase net wages without increasing profits, a desirable outcome to make
work more attractive or to stimulate aggregate consumption."






All in all, it seems that we will observe a transfer from workers to employers after all. This will contribute further to the decrease in the families' disposable income and to the number of private insolvencies in the country. Several questions remain. Will the positive effect of the decrease in SSC for employers outweigh the negative impact of the decrease in domestic demand? If they do, what will the firms do with increased profits? One has to be extremely careful about the non-tradables sector. So far, I haven't seen any policy announcement in this regard. The capacity of the government to regulate the firms in order to make them shift their eventual savings into more employment creation or price decreases is a fundamental political test which will shed light on whether this government is really catering for the special interests of a few firm share holders or the general interest. Let's wait and see.

Keep reasoning

A tale of mixing two policies

Policy 1: Fiscal consolidation (FC)

In his massive fiscal consolidation effort, the actual Portuguese Government had decreased public wages by suppressing the 13th and 14th months (called Summer and Christmas subsidies in Portugal). Later the Portuguese Constitutional Tribunal (TC) found that this was illegitimate because it went against the equity between private and public workers (!) and forced the government to give back one of the subsidies. 

The immediate implication would be an increase in public expenditure and a worsening of the deficit. 

To maintain the decrease in expenditure the Government decided to increase the social security contributions (ssc) paid by public employees by 7% (which is equal to 1/14). Consistently with the TC the increase in ssc is extended to all the workers (remember the private-public equity).

transition to…

Policy 2: Fiscal devaluation (FD)

Now you find yourself with an increase in 7% of the ssc paid by private employees which allows you to decrease social security paid by all firms by 5.5% (assuming public employees are 15%-20% of total employees). 

The willingness to maintain the decrease in public expenditure, and avoid a further increase in the deficit created the room for a fiscal devaluation. A "creative" FD as this is not what was suggested in previous studies/posts. My preliminary bird-eye view is that 

- in the long run total TSU has increased, therefore the labor-wedge has increased. The increase is small, 1.5%, but goes in the wrong direction, augmenting the labor market distortion.

- in the short run, the efficacy on competitiveness crucially depends on which wage is rigid: the net nominal wage (take home) or  the nominal wage gross of social security. In the original version of the FD (with VAT), when the decrease in TSU paid by employers decrease, the nominal take home wage is assumed not to increase which allows the gain in competitiveness. In this version of the FD, the nominal take home wage decreases because of the increase in ssc paid by employees. 

There are other differences between the FD with VAT and SSC paid by employees. Especially on the negative impact of demand. I am not going to tackle them here. I will underline the need to introduce some progressivity in the TSU.

At present Portugal needs to maintain its calm, avoid precipitous decisions and present clear-minded scenarios together with policies and their trade-offs.

      

Portugal is in shock

These days, everybody in this country is shocked in a way or another and I am choked in my own way, of course. The reason for all that shock is the Government’s plan to change the social tax (Taxa Social Única), which will lead to an increase in labor's taxation by 7 pp (from 11 to 18%) and a reduction of employers taxation by 5.75 (from 23.5 to 18%; the remaining being an increase of the aggregate from 34.5 to 36%). Such change will imply a massive transfer of wealth from workers to employers, to the tune of 2.2 billion euro annually. But even more shocked I get when I read in the Portuguese press that the IMF's Director, Christine Lagarde, has stated that Portugal is "a success story in the eurozone". Following massive cuts in public wages, massive tax increases, and massive cuts in health, education and unemployment compensations, that success is measured by a 6.6% deficit over GDP, and unemployment estimated to reach 17%, by the end of the year. I wouldn’t call that success. One my just wonder how the 6.6% deficit is esasily compatible with a much lower unemployment rate (12, 13%?, your pick). Both staggering figures are the direct consequence of the way the crisis has been tackled by the close and unhealthy association we have in this country between the troika and the Government. And now everybody is also worried about what will happen politically in the near future.

Review literature on Fiscal Devaluations

Given the recent measures adopted by the government I post a small reading list on Fiscal Devaluations for the interested readers.

1. Emmanuel Farhi Gita Gopinath Oleg Itskhoki: Fiscal Devaluations
2. Ruud de Mooij, Michael Keen: Fiscal Devaluation and Fiscal Consolidation: The VAT in Troubled Times
3. Francesco Franco: Improving competitiveness through a fiscal devaluation: the case of Portugal (first attempt/cross section)
4. Francesco Franco: Adjusting to external imbalances within the EMU, the case of Portugal (second attempt/time series)

Back to national homework

As the plan for a deeper integration of the euro financial markets proceeds, ez-members need to continue their focus on macro rebalancing. An important aspect of the rebalancing relates to their fiscal consolidation plans. A new paper by Alberto Alesina, Carlo Favero and Francesco Giavazzi finds that: 1. Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. More precisely: tax-based adjustments have been associate with prolonged and deep recessions while spending based adjustments have been associated with mild and short-lived recessions. 2. The heterogeneity in the effects of the two types of fiscal adjustments is mainly due to the response of private investment, rather than that to consumption growth. 

A Coherent Bund ?

I am puzzled by the primary market operations performed by Finanzagentur and its agent, the Bundesbank. Consider yesterday auction of the 1.5% bond of the Federal Republic of Germany of 2012 (click for official press release).
My reading is as follows:
The issue volume was 5 billion euro. Bids by primary dealers (institutions that have to take the bonds) amounted to 2.77 billion while bids by banks and other private agents summed 1.16 billion. Total Bids were 3.93 billion, well below supply. The Bundesbank accepted 100% of the bids by the primary dealers and approximately 72% of the competitive bids. Price did not respond because supply was artificially lowered through the retention mechanism: 1.39 billion of Bund were set aside in the account of the Federal Government (I presume an account at the Buba). The result is an average yield of 1.42% on the Bond. 
Why am I puzzled? I thought that interest rates in Germany were too low (and in Italy too high) according to fundamentals. If this is true, how are German auctions coherent with a normalization of the interest rate differentials and of the overall monetary policy transmission within the eurozone?
P.S.
Admittedly 5 billion is very small and practically there is a flight to quality (es: Siemens borrows at 0.375% for 2 years). Nevertheless coherence might be a good starting point. 

P.S.2
I am told that  my labeling of non-competitive bidders as primary dealers is imprecise. Most of them are primary dealers but not exclusively, they are bidders that focus on quantity instead of price and are willing to take paper at the average price.

On Fiscal Unions

Important paper by Emmanuel Farhi and Ivan Werning on Fiscal Unions. (A reading to be reconcilied with macroeconomics if needed).

Three questions to European leaders

I have been asked to prepare a short question for the european summit in October. I have prepared three. They are broad and purposely rethorical to quench my impatience.

I.

To date the Eurozone is the most highly civilized arrangement between former warring states to provide public goods of primary importance: peace and prosperity. By constructing  the Union, Europeans, want to maintain their status of paragon among other regions of the planet. 

Can you describe what would be the consequences for the international order of a failure of the European project?

II.

Do you think that the current institutional framework is able to provide for consistent macroeconomic policies in periods of calm and rapid and responsible decisions during period of crisis, or is it prone to free-riding behavior and naive "fallacy of composition" analysis by individual members?

III.

The current narrative ascribes the incapacity of European leaders to agree to the war between two world views. It is again the old dispute between the short run and the long run. (Strangely enough we had been taught that the dispute had been settled by the Samuelsonian neoclassical synthesis.) When do you think European leaders will present and offer a shared analytical framework on the economic functioning of the Eurozone?

4th revision update

the new documents from troika on Portugal, are available here, from the site of the Portuguese Government.

An update on wage adjustment

I am still looking for the quarterly time-series but I have managed to find data on General Government employment for 2010 and 2011. This was useful to compute the average compensation inflation (click to enlarge the graph) in the public (blue line) and private sectors (green line). So far the adjustment for the total economy (red line) came in large part from the public sector.

Public and Private compensation query

Query: I am trying to compute a measure of private labour compensation inflation. So far I have been unable to find quarterly data to subtract General Government (GG) compensation from Total Economy (TE) compensation. The annual national accounts by branches (Eurostat/INE) presents the data for the TE and the GG although GG employment ends in 2009. Does anyone knows where to find updated and quarterly data?

Bt the way: the graph above shows: 1) an average compensation premium of 1.95 for GG workers (obviously characteristics are different), 2) similar inflation compensation until 2009 (GG average 4.6, TE average 4.35, correlation 0.75), 3) a declining share of GG employees.