European macroeconomic figures

The Economist published a very interesting macroeconomic figures comparing European countries regarding three main indicators; state of the economy, debt and growth. The indicators of the state of the economy portray GDP per capita, unemployment rate and youth unemployment. Not surprisingly, countries with the highest unemployment rate are Spain, Greece, Lithuania and Slovakia. Counties with the most envious youth unemployment rate are Austia, Netherlands, Germany and Slovenia. Debt indicators consist of public debt, budget balance and average debt. The most interesting figure in this respect is public debt. The economies with the most heavily indebted governments are Greece and Italy while the countries with the lowest indeptedness are Bulgaria and Estonia. The latter was one of the first counties that prohibited public sector borrowing. Growth indicators are divided into three parts; annual GDP changes, latest GDP and annual GDP forecast. The forecast suggests that the most favorable growth prospects are expected in Lithuania, Estonia, Sweden and Poland. Negative growth prospect are expected for Greece and Portugal. Overall, the aggregate figures suggest that macroeconomic future of Europe will bring several yet unexpected changes.

Fertility, Earnings and Taxes

The persistence of low fertility rate is one of the many factors inhibiting the stability of public pension systems in developed world. From the 20th century onwards fertility rates have plummeted in all countries that belong to high-income group. The causes of this systematic drop in average fertility rates could be attributed to income affects of higher education and human capital as well es to greater perticipation of women in the labor market. The fertility rate used to stand above average in countries where the dominance of hierarchical religion has been present. Catholic countries such as Ireland, Portugal and Spain were known for extensive influence of religion on fertility decisions regarding the number of children. Thanks to greater use of contraceptive means, the fertility rates in those countries have stadely converged to the level of fertility in Protestant countries. In recent years, the fertility rate in Catholic countries has been ranked at the bottom in high-income country group.

In concidering the features behind lower fertility rate, the influence of taxation of labor supply has been neglected. In Catholic countries, the rate of female participation in the labor market was significantly lower than male labor perticipation rate. The spread of the welfare state in developed countries in the 20th century led to significant spikes in marginal tax rates on labor supply. For instance, 45 percent marginal tax rate implies that from each additional dollar earned, 45 cents go directly to the governement. The implication is that tax burden of labor supply nearing predatory levels does not encourage men and women to spend more time in the labor market. Consequently, the level of earnings decreases in the course of life cycle, further reducing the parental willingness to increase family size.

It is difficult to reverse the tax burden of labor earnings since the continuous growth of the welfare state amassed significant financial labilities of the government. To boost fertillity rate, it is essential to expand incentives to participate in the labor market, postpone labor market withdrawal and increase the family size. Without a prudent reduction of marginal tax rates and effective tax burden of labor supply, the Western world will experience decades of stagnating fertility rates whose negative impact on the stability of public finance could be difficult to reverse.

Spain's labor market reform

According to WSJ (link), Spain has finally implemented the broader reform of the labor market structure. Spain's 20 percent unemployment rate is the highest in the Euroarea. Traditionally, Spain was known for its notorious and heavily regulated labor market. The country used to maintain high levels of minimum wage and high cost of dismissal. The reform introduced by the Zapatero government removed the restrictions for dismissals on a fair basis and deregulated dismissal procedures on indefinite labor contracts. Dismissal cost has been decreased from 45 days to 33 days of salary per year worked.

The labor reform in Spain led to a lot of controversy among economists. Dani Rodrik (link), for instance, claims that labor market deregulation and fewer firing restrictions will further increase the unemployment rate since the major cause of it is the lack of labor demand. On the other hand, a handful of economists claim that Spain's persistent labor market rigidities are the major cause of country's high unemployment rate.

According to World Bank, redundancy cost in Spain averages 56 weeks of wages, more than twice the OECD level. During recessions, the decline in labor demand usually increases the unemployment rate and, therefore, hiring and firing restrictions do not exert the major influence on firm's decisions to employ additional units of labor. However, the persistence of strong labor market regulation imposes significant economic costs.

First, firms do not employ the optimum amount of labor. High redundancy cost and rigid dismissal procedures lead to either under-employment or over-employment of labor. Thus, firms shift the burden of high labor cost on higher prices, lower dividends and lower net wages.

Second, labor market regulation has broader implications. It eventually leads to more institutional rigidities and more pressure on higher wages by trade unions through collective bargaining. Consequently, wages become downward rigid. During the economic recovery, firms are therefore less motivated to employ new workers or extend the existing labor contracts.

As Spain finally recovered from the recession, the ongoing labor rigidity and even the increasing labor demand could not alleviate Spain's high unemployment rate. It would only put more pressure on Spain's government to increase government spending on unemployment schemes. Therefore, the reform of the labor law based on labor market flexibility is the most plausible alternative for Spain to boost employment and decrease the widening budget deficit that threatens country's economic recovery.

Should Bush tax cuts be extended?

According to WSJ (link), the majority of surveyed economists in the U.S. suggests that Obama administration should extend personal income tax cuts imposed under Bush administration between 2001 and 2003. Given the dismal effects of $787 billion stimulus, the U.S. economy would greatly benefit from tax cuts on earners in all income brackets. However, is the administration under president Obama willing to reverse the growing trend of government spending?

Critics of Bush tax cuts claim that reduction in personal income tax rates between 2001 and 2003 resulted in a disproportionate windfall gain to the wealthiest U.S. households while the families in the lower tail of income distribution received very low or zero gains from 2001-2003 tax cuts. What would happen if the Obama administration extended tax cuts for all taxpayers? Would the reduction of tax burden lead to stronger and faster U.S. economic recovery? To answer the question, it is essential to understand what actually happened with the U.S. economy when Bush tax cuts were implemented.

Between 2001 and 2003, Bush administration enacted a series of tax cuts aimed at boosting the recovery of the U.S. economy from the 2001 recesion. In this year, tax rate on income in the lowest bracket was reduced to 10 percent while top marginal tax rate was slashed to 35 percent from 39.6 percent. Tax rates were also reduced for middle-income earners. In 2002, the administration reduced tax burden on new business investment while in 2003 tax rates on dividends and capital gains was decreased. These measures were a part of broader $1.35 trillion tax cut program approved by the Congress over a ten year course.

However, tax cuts didn't pay for themselves as President Bush promised. The reason is the growth of federal government spending which increased by 2.5 percentage points of GDP between 2001 and 2008. During his term, President Bush signed the so called Medicare Part D plan which assured seniors additional drug prescription. The act created $8.4 trillion in unfunded obligations in present value terms. The CBO (Congressional Budget Office) estimated that extending Bush tax cuts would cost the U.S. Treasury $1.8 trillion in the following decade and would dramatically increase the federal budget deficit.

The war in Iraq was the major source of a growing public debt. Between 2001 and 2008 the federal public debt increased by 5.4 percentage points of GDP. Due to the growth of government spending, tax cuts led to a widening budget deficit. It should be noted that tax cuts were not the cause of the 2008-2009 budget deficit as critics often argue. An analysis by Center for Budget and Policy Priorities has shown that Bush tax cuts account for about 25 percent of the 2009 federal budget deficit.

If tax cuts are not accompanied by the reduction in government spending, the outcome is likely to result in either budget deficit or growing public debt. This is exactly what happened in the medium term with Bush tax cuts. A reduction in tax burden on personal income can result in higher tax revenue only if government spending is reduced. The U.S. budget outlook suggests a dismal fiscal future for America, marred by high public debt and a wide budget deficit that is unlikely to disappear before 2017. Bush tax cuts should be extended for earners in all income brackets, but only under a permanent reduction of government spending. Otherwise, any further tax cut would only add to the magnitude of federal budget deficit.

Natural resources and prosperity

Does natural resource abundance lead to more wealth and higher growth? This is an ample question of economic growth theory. In addition, many episodes of economic consequences of resource abundance suggest there is no single relationship between resources and growth. Many countries around the world are economically dependent on the supply of natural resources, especially in least developed and developing countries. In spite of significant amount of resources such as oil, coal, natural gas, gold and other commodities, many developing nations remain undeveloped and vastly dependent on foreign aid.

Countries such as Iran, Libya and Venezuela are among the largest oil-producing developing countries. In spite of vast supply of commodities, the data and experience do not suggest a positive impact of resources on economic growth. Prior to the 1979 Islamic revolution, Iran used to be one of the most developed countries in the Middle East. After 1979, Iran underwent an overhaul of its economic system and a beginning of large-scale state intervention in the economy. The theocratic government regime de facto suppressed private property rights and imposed strict government control over the economy. Even though Iran's oil reserves have been among the largest in the world, country's GDP per capita and structural indicators have stagnated since 1979.

Venezuela is a brilliant textbook example of how resource-abundant economy can stall as a consequence of socialist political dictatorship and unlimited constitutional power of the dictator. Libya is attributed with the largest supply of oil in Africa. Country's oil sector accounts for 95 percent of export earnings, 60 percent of public sector wages and 25 percent of GDP (link). Even though the country is the largest oil exporter in Africa and despite a GDP per capita in the rank of Russia and Lithuania, the unemployment rate is estimated at 30 percent which is the 21st highest unemployment rate in the world. In addition, Libya's business environment is marred by the lack of economic freedom resulted from high degree of corruption in public sector and judicial system. According to Heritage Index of Economic Freedom (link), Libya is the least free economy in North Africa and Middle East which is nonetheless unsurprising since in 1978 all private property rights for private businesses were eliminated.

Resource abundant countries also used to be expropriated by the colonizers in the age of colonization. Early colonizers of a vast majority of African resource-abundant countries did not focus on the permanent establishment of sound property rights and contract enforcement but solely on the extraction of natural resources. This created huge political instability and intense war conflicts on the African continent. On the other side, there are countries with abundant natural resources and high prosperity at the same time such as Norway and Canada. The political history of these countries suggests an entirely different institutional setting, based on the protection of private property and contract enforcement. Such a structure and origin of the legal system ensured low transaction costs and sound contract protection by the judicial system as the basis of economic development.

After centuries of socialist political and economic mismanagement, dictatorships in Africa and the Middle East resulted in the artificial wealth illusion demonstrated by relatively high GDP per capita and poor structural indicators such as high unemployment rate. Therefore, one should be cautious in examining the relationship between natural resources and economic growth in the longer run. Nevertheless, institutional, historical and political background of resource abundance should not be neglected.

The economic nonsense of corporate income tax

The share of corporate income tax in tax revenue has been growing in the last two decades in the majority of countries. Beginning in 1990s, policymakers in developed countries have trimmed corporate income tax rates in the hope of fewer distortions to saving and investment. As a consequence, tax revenues from this particular tax have increased as a share of the GDP. Surprisingly, leaders in corporate income tax reduction were high-tax European countries such as Sweden, Austria and Germany. Today, the lowest corporate income tax rates in developed world are found in European countries such as Cyprus and Ireland.

What is the economic feasibility of corporate income tax? In fiscal theory, the rationale for this particular tax lies in the existence of benefits from legal protection enjoyed by the corporations and private limited companies. Joseph Stiglitz has argued that this particular tax is a tax on entrepreneurship as it discourages new capital formation. Corporation's tax base depends on the amount of revenues minus expenditures for labor, materials and capital goods. The real paradox of corporate income tax is that it is preferable for the corporation to create new debt than to issue equity. In fact, the debt is considered as a deduction from corporation's tax base. Thus, it is difficult for start-ups to get the loan from the banks as the bank is not willing to take on the risk involved with the repayment of the loan since start-ups' success is uncertain. Therefore, the existence of corporate income tax hinders business investments and entrepreneurial activity in general.

The abolition of corporate income tax would be an important boost to capital formation and new business investment. In addition, many economic distortions would disappear. It should not be neglected that tax incidence in corporate income tax is not shifted to the corporation. The ultimate payers of this tax are workers, customers, suppliers and shareholders. The tax is shifted in lower wages, higher prices and lower dividends. At last, the tax also creates perverse incentives that discourage investment and, nevertheless, job creation.

Source: OECD Tax Database (link)

Benefits of immigration

The Economist wrote an interesting article on the significance of migration and important spillovers from immigration into developed countries. The economic crisis of the past year has slowed the flow of international migration. As the estimate from Migration Policy Institute suggests, the stock of illegal immigrants in America fell from 12.1 million in July 2008 to 11.9 million in the year after. It is important to emphasize the economic benefits of migration for developed and developing countries.

The migration to developed countries has resulted in higher employment and greater specialization in the labor market. Without the flow of migrants the structure of the labor market in developed countries would incentivize workers to take lower paid jobs which would result in lower incomes. As the developed countries opened their borders to immigrants from all over the world, young individuals were enabled to invest in human capital and by doing so increase their career prospects. As for developing countries, migrants increase the stock of human capital availible to the country of migrant's origin. Therefore, immigration from less developed countries should not be seen as a loss but as an immense opportunity to get the know-how and high skills through which the country of migrant's origin shall prosper. The widespread emergence of technologies such as Google's applications, Twitter, Facebook, Linkedin etc. has further enhanced the flow of knowledge and information to the countries of migrant's origin. It should not be neglected that economic catch-up, generated from technological imitation, is the only way for less developed countries to reach the income per capita of their richer peers.

The OECD published a report where it estimated that the inflow of migrants to rich countries fell by 6 percent in 2008, to 4.4 million. Five years before 2008, the inflow of migrants soared. The main benefit of immigration is more favorable demographic outlook since developed countries will experience sharp increases in the share of older population (65 years and over), replacement rate and fiscal burden of entitlement spending. The inflow of immigrants not only benefits the labor market but it also boosts incentives to work, save and invest since immigrants work longer hours and retire later than native population. Therefore, immigration should not be discarded but encouraged and promoted by national governments.

The impact of crisis on employment

In recent days, Greek public sector workers have launched protests against government austersity measures which include a cutback in minimum wages, public pensions, an increase in effective retirement age and a cut in entitlements. An interesting question is how the crisis affected employment outlook across the world. The OECD recently presented a brief overview of unemployment dynamics in member states (link).

The countries, least affected by the crisis in terms of unemployment surge, are the ones with strong and flexible institutional foundations of the labor market such as the flexibility of wages, the ease of firing and hiring, tax wedge and the linkage between productivity and wage rates. These countries are, for instance, Austria, The Netherlands, Korea and Norway. The surge in unemployment has been the most significant in countries such as Spain, Ireland, U.S. and Iceland where the banking and financial crisis have torn real income and employment by heavy spillover of financial shock into the real sector. It is important to emphasize that long-term employment outlook in OECD countries will be determined by wage flexibility and regulatory environment which is essential and conducive to job creation besides economic growth and unit labor costs.

Productivity gap between the US and OECD countries

I collected data from the OECD on GDP per hour worked in each country as a percentage of the US level. The highest level of GDP per hour was found in Luxemburg (140.4 percent of the US level), Norway (136 percent of the US level) and the Netherlands (100.4 percent of the US level). In these countries, the level of productivity is higher as the workers there work fewer hours per year than in the US, so it is no surprise that relative productivity is higher. The least-performing countries are Poland (37.9 percent of the US level), Mexico (33.6 percent of the US level), and Chile (28 percent of the US level). These countries are catching-up developed nations, so in spite of relatively high number of working hours per year their level of productivity is significantly lower.

In the long run, productivity is the only engine of economic growth and the wealth of nations. It is the only hope for less-developed and developing nations to catch the income per capita level of advanced countries. There are many obstacles to higher productivity in the labor market. First, many countries impose minimum wage laws, risking higher unemployment among less-skilled workers. Minimum wages increase labor costs and reduce overall employment. Second, the number of working hours is often restricted by trade union determination of labor contracts and entry requirements in many sectors. Third, some countries reduce labor supply incentives through higher hourly wages on extra working hours so that employers do not encourage employees to work longer hours. And fourth, high marginal tax rates discourage workers from longer work. A reduction in marginal tax rates, the abolition of minimum wages, deregulation of entry requirements and tax incentives for extra hours of work could significantly boost productivity growth and higher standards of living.

GDP per hour in OECD countries

Source: OECD (2010)

IMF Borrowing Crisis

The graph shows 10 largest borrowing arrangements by International Monetary Fund (IMF). Recent $140 billion rescue package for Greece is one of the largest cradit loan arrangements in the 21st century. The fund's contribution to Greece has surged the overall indebtedness of the Euroarea. During the financial crises IMF usually extended credit lines to the countries in trouble. Recently IMF extended borrowing arrangements to Latvia and Iceland. Before Greek rescue aid, IMF's contribution to Iceland's rescue package was one of the largest borrowing expansions ever given to such a small country. In the future, as emerging economies will further grow, IMF will have to be keen on the possibilities of systemic crises in these countries. The IMF should not extend the rescue loan to every country as this is not always effective in the end. The main purpose of the IMF is to help counties facing balance-of-payments crisis and not being the borrower of the last resort as in the case of Greece.

Source: The Economist

Italian Big Government

The figure from The Economist showes that the number of official cars on the streets in Italy is 6 times as much as in the average European country. The figure doesn't seem to reflect the terrible state of the Italian economy. In 2009, Italy's public debt grew up to 115.3 percent of the GDP. Given the worrying state of public finance, Italy's one of the riskiest countries in the Euroarea. It is a country of an enormous contrast between the developed North and the agrarian South. The country also has one of the largest shadow economies and widespread corruption perceptions in the developed world. Because of reginal income per capita disparity, Italy is a country of significant differences in youth and adult unemployment across the country. According to the OECD, Italy has one of the highest youth unemployment rates in the EU (26.3 percent). In the last year, youth unemployment rate in Italy grew by 5 percentage points. The proportion of youth in employment is 20 percentage points below the OECD average.

Source: The Economist

Mortgage crisis in the UK

Bank of England published a very interesting survey of household financial conditions in the UK. The following graph shows quarterly percentage changes in the house purchase and remortgaging dynamics in the UK between Q2:2007 and Q1:2010. As the graph indicates, there is an excess volatillity in the housing market as a result of loose monetary policy and unpredictable mortgaging changes. Housing markets reflect the instability of the UK economy.

House purchase and remortgaging dynamics in the UK

Source: Bank of England, 2010 (link)

Youth unemployment in OECD

Youth unemployment is one of the major macroeconomic problems in the OECD countries. High youth unemployment rates are a significant concern mainly because joblessness affects housing market, inflation outlook and demographic picture. Persistent unemployment rate means less purchasing power and a strong downward pressure on prices.

According to the latest data for 21 OECD coutries, the highest youth unemployment rates (15-24 years) in the fourth quarter in 2009 were in Spain (43.6 percent), Slovak Republic (31.9 percent), Ireland (29.1 percent) and Hungary (28.8 percent). The labor market outlook in Spain is very worrisome given the fact that almost half of the young population is jobless. Spain's youth unemployment is almost 4 times the youth unemployment rate in Germany (10.2 percent). The OECD forecast a growing unemployment rate until 2011, which means that current unemployment figures could get worse in the coming years. The lowest youth unemployment rates were found in Netherlands (7.6 percent), Norway (8.9 percent) and Korea (9.4 percent).

Youth Unemployment Rate in Q4:2009 in OECD

Source: OECD (2010)

The biggest difference between youth and adult unemployment rate was in Sweden where youth unemployment rate was 4.3 times higher than adult unemployment rate. Similar differences were found in Norway and Luxembourg (both 3.87). The smallest differences were found in Germany (1.42), Portugal (1.96) and Denmark (2.03).

Youth-to-Adult unemployment ratio in Q4:2009 in OECD

Source: OECD (2010)

Economic freedom and the wealth of nations

Today, I would like to present the impact of GDP per capita on economic freedom across the world in 2010. Economic freedom is a measure of country's freedom to invest, consume, work and produce in any way pleased. It is also a measure of state's protection of private property rights under the rule of law. In the graph, I compared the GDP per capita (PPP-adjusted) in international dollars and economic freedom score from Index of Economic Freedom. The index ranges from 0 to 100; where higher number indicates higher level of economic freedom.

As you can see, higher GDP per capita is associated with more economic freedom. I found that if GDP per capita increases by 1000 USD, economic freedom score, on average, improves by 0.6 percentage points, all other remaining constant. In addition, 48.03 percent of the variation in economic freedom is explained by the variability of GDP per capita.

Economic freedom is an essential determinant of economic development. The lack of institutions of private property, rule of law and contract enforcement is the main source of economic underdevelopment and contemporary stagnation in the third world.

It is not natural disasters and the lack of humanitarian aid that keeps Haiti poor but the absence of economic freedom which has lead to widespread corruption in judiciary, business and politics, and to the diversion of investment out of the country. Haiti's economic freedom index (50.8) is among lowest in the sample of 50 countries.

The least economically free countries are Venezuela (37.1), Libya (40.2), Belarus (48.7) and Russia (50.3). The best performing countries in economic freedom are Australia (82.6), New Zealand (82.1), Ireland (81.3) and Switzerland (81.1).

Economic freedom and GDP per capita in 50 countries

Source: Heritage Foundation, IMF (2010)

Tax and labor cost

I composed a graph from Eurostat's database on tax wedge in EU, US, Iceland, Norway and Switzerland in 2008. Tax wedge is a measure of overall tax burden of labor cost. It shows the share of taxed labor cost. It is striking to see that EU goverments take in almost half of what you earn. Tax wedge is the highest in Belgium (50.3 percent). Hopefully, it does not set an example to the rest of EU countries, as EU15 tax wedge is over 40 percent. After all, EU15 is known for high tax burden. As you can see from the graph, tax wedge is the highest in Continantal Europe. Germany, one of the biggest EU economies, scored second with 47.3 percent, next is Hungary (46.7 percent) followed by France (45.5 percent), Austria (44.4) and other countries. All countries that scored above 35 percent should implement some radical reforms and so became more competitive and attractive for doing business. One of the countries that achieved to reduce tax wedge the most is Cyprus (0.0 percent), second best is Malta with 17.9 percent, Iceland (23.7 percent), Switzerland (26.5 percent), USA (28 percent), Luxemburg (29.6 percent) and UK (29.7 percent).

Source: Eurostat

International comparison of housing prices

The Economist collected quarterly data on housing prices between 2003 and 2009. It is interesting to see how housing markets in different countries were affected during that period. You can roll over the chart here.

UK's public debt crisis

Financial Times reports that UK goverment borrowing spiralled out of control and is the worst in Britain's postwar history. In the past financial year, government borrowed 163.4bn GBP. In 2010, public sector net debt is expected to rise up to 53.8 percent of national income, up from 44 percent last year. Britain is in serious public debt crisis. That is why it is in an urgent need of the rebirth of Thatcherism and Reaganomics.