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.

The Consequences of Lower Fertility Rate

One of the major challenges that modern world has to face is the reduction of fertility rate. Lower fertility rate leads to demographic imbalances. Demographic pressure on public finance will be enormous since the share of population above the age of 65 is expected to rise rapidly. Western world is undergoing a massive aging of the population. In the 20th and 21sth century, birth rates in Western countries have fallen considerably. Consequently, the share of population 65+ and old-age dependency ratio have increased extensively.

One of the most notable consequences of aging population is an enormous pressure on the long term sustainability of entitlement spending. If public pension and health care systems will not adjust to changes in fertility rate and labor market entry and exit age, an ageing population might easely undermine the ability of public finance to cope with the burden of old-age dependency.

The economic pressure of ageing population will inevitably require the adjustment of tax and spending policies. A growing share of dependent population implies that tax burden disporportionately falls on the working population. The growth of net financial liabilities and current effective tax burden strongly distorts labor supply decisions. Higher implicit tax rate during the working age might easily reduce the fertility rate and keep replacement rates below the demographic equilibrium level. Higher tax burden would then reduce the incentives for having children since the loss of consumption in the working age would stream into prospective periods. In addition, Western countries will have to tackle the issue of early retirement. Empirical evidence suggests that early retirement costs Western countries from 5 percent to 10 percent of the GDP each year.

The growing share of population 65+ leads to changing political landscape. Pension spending would be difficult to reverse if age-dependent population represented a significant share of the voting body. This might trigger the incidence of pensioners' parties in national parliaments which could substantially halt the prospects of pension reform. In any case, age-dependent population would be able to subordinate the preferences of political parties. That would diminsh any plausible possibility of a much needed pension reform.

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.

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)

US health expenditures

The US has the highest percentage of health expenditure in OECD countries. The finding is surprising given the fact that the role of government in US health care delivery is among the smallest in the world. However, health insurance in the US is conducted through insurance companies and not directly between the patient and health-care provider. Such interaction creates the third party payer problem. Much of the health insurance in the US is provided through employer mandates. Such a scheme entitles employers to buy health insurance on behalf of employees via insurance company. The scheme, due to the lack of direct payment, creates the so called moral hazard, giving employees incentives not to provide themselves with full insurance coverage. Average American spends $7.250 on health per year, which is more than two and half times the average expenditure in the OECD ($3.000).

The US health-care reform should focus on deregulation of health insurance market across the country. The provision of free interstate health insurance market would force insurance companies to cut predatory premiums and end insurance denials to their customers. In addition, health-care reform should encourage out-of-pocket payments given the fact that these payments are strongly correlated with overall health conditions. Switzerland enjoys one of the highest life expectancies in the world alongside very high out-of-pocket payments for health care. The US should move in the direction of elimination of employer provided health insurance. This step would gradually reduce the size of health expenditures and would also contribute to the reduction of the number of uninsured.

Health Expenditures in the OECD

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

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

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.