The Eurozone

With the Greek and Irish bailouts, there always seems to be a whispering about the stability of the Eurozone.


My question for today is what makes the United States different from the Eurozone?


One suggestion offered in the article that piqued my interest in the topic (here) offers the suggestion that federal transfer taxes keep America more homogeneous. In fact, when you look at the data, there is absolutely no correlation between per capita taxes paid to the government vs per capita expenditures received. However, there is a strong negative correlation between income per capita and the ratio of taxes paid vs expenditures received.


While I'm not sure that is the whole picture, it is certain that the US is more homogeneous.


Here is a listing of Eurozone countries by GDP per capita:

	Population	Nominal GDP	GDP/capita
Luxembourg	491,702	52,449	106668
Ireland	4,517,758	227,193	50289
Netherlands	16,481,139	792,128	48063
Austria	8,356,707	384,908	46060
Finland	5,325,115	237,512	44602
Belgium	10,741,048	468,522	43620
Germany	82,062,249	3,346,702	40782
Italy	60,090,430	2,112,780	35160
France	64,105,125	2,112,780	32958
Spain	45,853,045	1,460,250	31846
Cyprus	801,622	24,910	31074
Greece	11,262,539	329,924	29294
Slovenia	2,053,393	48,477	23608
Portugal	10,631,800	227,676	21415
Malta	412,614	7,449	18053
Slovakia	5,411,062	87,642	16197
Eurozone	328,597,348	12,455,979	37907

Look at that range! The US states range only from Connecticut at 54,397 to Mississippi at 30,103. 


This same divergence is seen in debt to GDP ratios. In the Eurozone, Debt to GDP ranges from 115% for Italy to 14% for Luxembourg. These countries likely differ in their reliance on imports and exports as well. State debt to GDP ratios are all below 20%, although that is because the federal government takes on much of the debt. However, this makes state defaults far less severe because the federal government can bail them out and it is simply a smaller dollar amount.


The Eurozone got this way through centuries of different economic climate and policy. Meanwhile, the US has generally had the same climate and policies throughout the states throughout its history. While all the US states probably need similar treatment, it may be that the eurozone is just too heterogeneous for one currency.

Predictably Irrational and Dan Ariely

I've always found what we learn in our basic economics classes to be woefully poor at explaining a whole host of real life economics behaviors. Luckily, the growing field of behavioral economics is starting to fill these yawning gaps.

In this fantastic TED talk, Dan Ariely explains some of the thought that went into his popular book Predictably Irrational, one of the two major books about behavioral economics (along with Nudge). Both come extremely highly recommended from me.

These are our wonderful elected officials

"No!" Representative Shadegg said. "Unemployed people hire people? Really? I didn't know that." He continued: "The truth is the unemployed will spend as little of that money as they possibly can."

http://www.slate.com/id/2276473/

Ok, so while I normally try to pretend to be non partisan (and people on both side hate most of my ideas), this particular image caught my attention.

This is the end result of a study by Princeton political scientist Larry Bartels. Of course, there may be other factors in here, we elect republicans when the economy is bad, democrats make it bad for the next guy, who is usually republican, but it is still interesting. Look at which dierection the curves go in.

Closing the Deficit

The deficit has been the subject of much debate recently. Everyone seems to agree that it needs to be reduced, but not how to do it. However, now, thanks to The New York Times, you can play the deficit game!

http://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html

Should we increase taxes? On whom? Should Social Security or Medicare be cut? What if we just eliminate agricultural subsidies? (Hint: that's not even close to enough)

For an interesting discussion about the deficit and what it means to be an economist, check out professor Howard Glaeser's opinion here:

http://economix.blogs.nytimes.com/2010/11/16/economics-offers-tactics-not-strategy/?partner=rss&emc=rss

Teaconomics discussion ideas

Comment here to post your idea for a discussion.

Progressive tax on banks by asset size

This idea is a bit more... contentious. I doubt that anyone in Congress would vote for this, unlike some of my other suggestions. However, this one has more merit than originally meets the eye, as it actually kills four birds with one stone.

First, it grapples with the problem of too big to fail. If a bank gets charged more and more of its income as taxes as it becomes larger, the equilibrium size of banks will be smaller. Banks would spin off some of their divisions, which usually increases shareholder and economic value in the process, as people who understand each aspect of the business better end up with more say in it. The only people who suffer are those at the very top, who don't get paid as well because they are now executives at smaller companies. The rate of increase of tax to asset size would determine the ideal size of banks, and that would have to be studied closely before putting this into effect.

Second, it forces banks who gain implicit government guarantees of bailouts, due to being so large, to pay for that guarantee. After the bailout, the country has both the problem of moral hazard and a competitive advantage for large banks. They can borrow more cheaply since the government will bail them out if they fail, and then they are encouraged to be more risky with it for the same reason. A progressive tax will make large banks less profitable and so will cancel out that competitive advantage, and encourage risk takers to go elsewhere so that they can keep more of their gains. This will make large banks much more secure.

Third, it controls leverage. Leverage was a major contributor to this crisis. First, it increases the size of an asset bubble, then when all the banks had to sell off all their assets at once, it caused at asset death spiral. As they sold more, prices went down, causing them to have to sell more, pushing the price down further, et cetera. With Morgan Stanley leveraged 32-1 at the beginning of the crisis, it could only take a 3% decrease in prices before becoming insolvent. This policy would control leverage because leverage increases assets, and as a bank became increasingly leveraged, tax rates would go up, increasing the cost of the next round of leverage and making it more and more unattractive very quickly. Controlling leverage is a very important part of preventing another crisis, and this policy would do it automatically, with the market determining the limit.

Finally, it has a counter-cyclical. This means that when the economy is hot, possibly overheating, it will cool it down, and when we are in a recession, it will provide a boost. It does this also through leverage. I have already explained how it slows leverage on the way up, but it also does the opposite on the way down. As asset prices decreased, the tax rate would down, making more leverage look more attractive. This new buying power would help buoy the market when prices were going down. Also, in would increase tax revenues during boom times and decrease them during recessions, providing a clear anticyclical effect, just like unemployment insurance, but without the hazard of encouraging people to stay unemployed.

All in all, this policy provides a whole range of positive effects, and is one that I would really love to see put into place. This policy by itself might be able to stave off another financial crisis if calibrated correctly.

Finance Compensation

The current compensation structure of finance employees is equivalent to what is called an option in finance. An option is a instrument where the downside risk is limited, but the upside potential is unlimited. In the US, where banks only recourse to foreclosure is seizure of the property, a mortgage is an option, because the property can increase in value infinitely, but the owner can only lose the house. An interest only, no money down mortgage allows a person to bet that the real estate market will go up without being able to lose any of their own money.


Finance compensation is an even sweeter deal than a no interest, no money down mortgage. They are always paid their salary, and the potential bonus is unlimited. This encourages risk taking, to make the biggest possible bonus because the possible loss is exactly zero. This is just pure economics. If I can make a bet where I can't lose, I'll make as big a bet as possible, and bankers and mortgage brokers did this. Before investment banks started going public, they were partnerships, and any money being bet for the firm was the partners money. Consequently, risk taking was limited because the partners were afraid of losing their hard earned money. Similarly, public owners should exert the same control over firms with the shares they own, but common shareholders have very limited control over companies they own.


The solution to the problem of risk taking on Wall Street is not to compensate with stock, or to limit compensation, but to force the employees themselves to invest a portion of their own personal money in every deal they make. Possible losses must be real to the employee too, or to the mortgage broker. This is how hedge funds work. Hedge fund managers are not considered credible unless they are willing to put their own money at risk in their fund. Why should it be any different for financiers?

Closing the Book Tax Gap

The book tax gap is an unfortunate result of the many arcane aspects of the tax code that few ordinary people know much about, but is extremely lucrative for those who do. The basic explanation is that the law allows a system of dual accounting that companies effectively use to practice two different accounting methods, one for reporting taxable income, and another for reporting revenue to investors. This is a questionable idea on the face of it, however, courts have upheld and even strengthened this practice through their rulings.

As companies are clearly interested in maximizing earnings, minimizing taxes paid to the government is perfectly understandable. Companies will choose two different accounting practices to achieve the maximum benefit. This current system of producing differing statements of income to investors and to tax authorities is ripe for exploitation. Corporations are never forced to choose the accounting standard that most accurately reports their income. Investors get the rosiest possible picture, while the government gets a more dubious version.

Despite increasing corporate tax rates and profits, corporate tax revenue has fallen sharply as a percentage of GDP from 1965 to today (Auerbach 8). Some large corporations haven't paid any taxes in years, including GE, Pfizer and the other pharmaceutical giants. The US Treasury’s 1999 white paper listed “lack of economic substance” and “inconsistent financial and [tax] accounting treatment” as the first two “common characteristics” of a corporate shelter (Whitaker 12). Essentially, by taking advantage of "tax preferred" items, many corporations can reliably reduce tax liability to zero.

Most companies use these dual standards without committing any fraud. More worrisome is the ease with which companies can use these standards to obfuscate their accounting, fool auditors, and commit outright fraud. As Wall Street Journal columnist Alan Murray has remarked, “lying to shareholders and lying to the IRS are just opposite sides of the same coin." Pressing the boundaries in one direction makes people think about the boundaries in the other (book and tax accounts). As anyone can see from the accounting scandals of Enron, WorldCom and others, very sophisticated companies can make their financial statements extremely difficult to decipher with creative accounting. The 2003 Joint Committee on Taxation report on the investigation into Enron’s book-and-tax accounting revealed that book-tax differences were critical to Enron’s financial misrepresentations (Whitaker 13).

Tax preferences create tax shelters which contain huge hidden costs. First, "By enabling firms to shelter book income from the IRS, the Code essentially gives corporations interest-free loans financed by the federal government—and ones that they will often never repay" (Whitaker 14). Second, the system is regressive, effectively taxing small and medium businesses at a higher rate. Finally, the cost of complying with the tax code is tax deductible, so the government also subsidizes creative accounting.

One solution is to choose a single accounting standard to apply to both financial and tax accounting. In a survey of hundreds of U.S. tax executives conducted a decade ago, a “significant number” of respondents endorsed book-tax conformity along book-income lines (Whitaker 18). Companies would be forced to report the same income and earnings to both the federal government, and to their investors. This would simplify compliance, and reduce losses from the system dramatically (Whitaker 33). This would also encourage corporations to report the most realistic number. They wouldn't want to overstate income because then they'd have to pay taxes on money they didn't earn, and they would want to understate their income because their stock price would decline. This solution offers more accuracy and transparency, something investors would certainly welcome.

On the other hand, the more radical solution of eliminating corporate income taxes altogether would solve the problem in an extremely simple manner. Since these taxes are only 6-10% of tax revenue, the loss in taxes could be replaced by a small VAT, or a small excise tax on all imports, etc, taxes that are more difficult to evade. This policy has numerous other indirect benefits. Businesses would still be taxed, but at a lower, flat rate, eliminating the subsidy for big business, helping small business compete. In addition, international corporations would be encouraged to headquarter in the US, where they could pay lower taxes, bringing more profits from abroad here. Though big business would now be forced to pay taxes, they would have a hard time lobbying against a flat tax that taxes all corporations equally, increasing the likelihood that this policy could succeed politically.

What do you think? Keep the current system, keep a corporate tax but make it simple, or eliminate it altogether?

Share your ideas in the comment section. Don't forget to click on subscribe by email so that you know when I comment on your comment. (You must log in to blogger to do this)

Sources:
Whitaker, Celia "Bridging the Book-Tax Accounting Gap" Yale Law Review, 2005. http://www.yalelawjournal.org/pdf/115-3/Whitaker.pdf
Auerbach, Alan J. "Why Have Corporate Tax Revenues Declined? Another Look" 2006. http://elsa.berkeley.edu/~auerbach/AJA_CESifo_revised.pdf