How far to soak the rich… Optimal top tax rates

You said it. Source: Google images.

A quick read from this morning’s press turned up an interesting article – Determining the optimal U.S. tax rate for high earners.  In brief, the author summarises existing economic literature which empirically estimates the top tax band (NB: the top tax rate in the US is currently 39.6%, compared with 45% in the UK).  He finds the top rate can and should be substantially higher, using 3 elasticity approaches.

Some thoughts:

• Background: tax policy is especially important in the US, relative to other countries, in order to achieve income redistribution.  Americans seem happier to use progressive taxation, rather than cash transfers, to help level the playing field.  Here’s some OECD data, summarised by Greg Mankiw, on the topic of US versus other countries in measuring tax progressiveness.
• The issue: policy makers need to set top tax bands to achieve both needed revenue and a feeling from society that the rich are paying their fair share.  The big concern is the substitution effect, which means the rich will work less as their effective (after-tax) pay is cut.  The measure of this effect is called elasticity, which is measured in 3 ways by the research quoted in the article.
• The result: in all 3 cases, the optimal higher tax rate is far above the existing rate – between 57% and 83%.  For history buffs, the latter is roughly where the top rate was in the 1930s-1950s.
• How can that be true?  From the article, it seems high earners don’t care about their marginal tax rate – again spitting in the face of rational economic theory.  Perhaps they’re working for other reasons than earning a lot, and/or still feel rich with high marginal rates.
• So what?  Part of me reads the article and feels the usual cynicism, e.g. “like that’ll ever happen”.  So worth asking why the US would raise the rates…maybe to squeeze just a bit more out of an already progressive tax system, in order to fund more progressive cash transfer system?  Also worth wondering what the elasticity would be for leaving town – testing the common argument that high earners will quickly leave town if rates are increased (e.g. London hedge fundies moving to Geneva when the top rate was increased to 50%, only to regret it later).  Finally, would hiking top tax rates actually raise additional revenue?  The elasticities in the article would hint at ‘yes’, but other authors suggest otherwise.

In sum: let’s put these findings in the basket of “hollow arguments the rich make to frighten working/middle class voters into voting against their best interests”.  Higher top tax rates may help raise revenue and social equality, with little effect on tax avoidance or decreased effort on behalf of high earners.

Friday reading: Andy Haldane of BoE on World Growth

I’m a big fan of Andy Haldane’s economic work.  An old favourite is his work on value investing versus momentum investing over VERY long time periods.

Anyway, his latest speech on economic growth is very interesting, well-researched, and utilises some great economic history to make a typically economist conclusion (i.e. ‘on the one hand…’).  In a testament to how visualising data can really guide opinion, I present the below from the speech:

Pretty interesting stuff. Source: BoE

Huh.  But that leads to this exciting chart (NB: note how arithmetic scale makes this much more powerful):

Whoa… Source: BoE

Happy Friday!

Political and economic sense…a difficult combo

The soundbite was good, but sadly not economically sensible. Source: Google Images

Going into this year’s UK general election – or the 2016 US Presidential election, a common thought I have is ‘why can’t politicians make economic sense with their policies’.  Some things, such as the looming pensions crisis or tax policy, just don’t get much airtime for trifles such as an actual accounting of economic impact.  These are generally left for agencies such as the IFS in the UK to communicate, which folks typically ignore.  Political parties seem to understand this well enough, so don’t engage in enlightened debate.

Anyway, my old colleague Rob has written a great treatise on this issue on his blog (link to the blog at right).  Thanks for the useful analogy, Rob.

Oil: when does good news become bad?

What does the excess of oil tell you? Source: Google Images

Continued crash in oil prices, with WTI breaking through stops at $47 to reach another low:

We’re awash in oil! Source: thinkorswim by TDAmeritrade

The recent press (e.g. here and here) is getting ambivalent, in my opinion.  What was once a definite ‘good thing’ for the world, and the US consumer, has now become a ‘well, let’s think about this’ as the price has continued to fall.  In particular:

• Who’s definitely worse off: our usual villains, such as Russia, Venezuela, Iran, etc.
• Who’s definitely better off: emerging economies which are big oil importers, such as India, Philippines, China.
• Who was definitely better off, but maybe not so much anymore: developed countries.  Why?
  • The consumer: Joe Bloggs is definitely better off at the gas pump, and maybe for purchased goods as well (e.g. transportation and manufacturing costs are lower).  For those in the US in particular, the strong dollar is an added bonus for the consumer.
  • The producer: Company ABC might be better off, depending on its relative dependence on energy.  For the airlines and shippers, as well as SUV producers, the lower oil price is a god-send.  For exporters, transit costs are lower, so should be helped.  However, a strong USD is bad for exporters, as well as multinational corporations with much sales overseas.  Worst of all are the oil companies themselves, obviously; some of these (more debt-laden, shale players) will likely go bankrupt.
  • The employee: decreasing oil prices lead to lower inflation, which means higher real wages for employees.  Thus, they should be happier – if they still have a job.  All those new jobs created in North Dakota and elsewhere, based on now-uneconomic shale oil/gas, are likely at-risk.
  • The investor/pension-holder: hmm – what to do?  Much has been written that oil/gas companies are HUGE providers of capital expenditure (thus needing investment, and paying returns) and dividends (helping those pensioners).  All of that is at risk now, with share prices falling accordingly.  All of the items above need to be in the investor’s mind as well – strong USD; better global growth prospects, particularly in emerging economies (partially offset by the USD); generally better news for developed countries, though maybe not too good.

In sum: while the falling oil price was once universally cheered by Western media, the news has become more mixed as ramifications of much lower oil prices are digested.

If only things were more black and white, eh?

Time for Americans to go on holiday…

The US Dollar index is off to a flying start, after finishing strong in 2014:

Up and away… USD index. Source: thinkorswim by TDAmeritrade

What’s going on?

• Eurozone worries: no secret that economic growth in the Eurozone is basically zero to negative.  Greek exit (‘Grexit’) is another real possibility, as their protest party is favoured to win a late-Jan election.  The world looks to ‘Super’ Mario Draghi of the ECB to instigate proper quantitative easing to help salvage the system.
• Japan worries: despite early success of Abenomics, Japan remains with very little growth.  The BOJ helped before with QE…maybe it’s time for another round.
• EM worries: China is slowing down.  Russia is a well-known loser due to oil prices.  Brazil has zero growth.  India is hanging in there, but for the most part folks are less willing to take the risk.
• What’s left? End of QE/higher rates in the US.  The problem with being the best of a bad lot is currency appreciation.  Portfolio effects (e.g. foreigners buying US assets for relative safety) means a solid bid for the USD.

In sum: the USD is at multi-year highs versus other currencies.  If you’re an American, considering a holiday, might I suggest the time for seeing the rest of the world is nigh.

A dire situation…or why it’s very fortunate to live in a reserve currency country

So Russia’s currency fell quite a bit yesterday, but today’s intervention by their finance ministry is stabilising things (so far, -ish) at around 70 RUB to the USD.  For those keeping track, that’s about a 50% devaluation since the beginning of the year.

Care for some RUB? Nyet. Source: Google Finance

OK, 50% seems like a crazy number.  What does it actually mean?  For most of us living in places like the US or UK, the idea of a currency depreciation doesn’t come naturally; unless we travel a bunch or have an export/import business on the side, FX rates aren’t an everyday concern.  But when your country imports 40% of food, for example, the situation isn’t pretty.  The lady quoted in the article is already paying 20% extra, a week into this depreciation.  People are worried what their salaries will buy.  This is sounding like the early stages of hyperinflation, where loss in the faith of a currency as a store of value can get bad, fast.

This is perhaps a concrete reminder of what gold bugs and Tea Partiers and such have been saying is the inevitable fallout from the Fed’s quantitative easing: namely, a dollar worth nothing.  They advocate buying real assets (such as gold, though I’ve already expressed my reservations there) to protect against a big dollar crash.

To be clear, however: the US and UK are very unlike Russia and other emerging countries.  The main difference, in this context, is having wide and deep financial markets denominated in domestic currency.  Let me explain:

• Who really has the power?  Lenders.  As much as we like to define power as military strength, in these days of relative peace the marginal power lay with the lenders.  Pretty much all governments rely on borrowed money to function; even the US government went through a completely idiotic own-goal by refusing to allow itself to borrow (NB: Tea Party, I blame you).
• What do lenders need?  Trust in borrower.  Remember that a lender’s best-case scenario is to receive back his principal + interest.  He can lose all of his principal.  In the case of US or UK, lenders are just fine receiving an IOU; they have faith they’ll be fully repaid.  With Russia and other emerging economies, lenders frequently require collateral; this frequently comes in the form of foreign exchange reserves, so lenders can seize ‘hard currency’ if needed.
• The key difference: domestic versus foreign currency borrowing.  Keep in mind that countries like the US and UK (and Russia) have fiat money, which means the USD and GBP (and RUB) are worth whatever the government and users say it’s worth.  Furthermore, all these governments have printing presses, allowing them to repay domestic currency debt with newly-printed money.  As a lender, then, the question becomes how likely you will be repaid with domestic currency worth anything.  If there’s doubt, the lender will only lend using (a more stable) foreign currency; for example, many emerging countries borrow in USD.  Once the borrower goes the route of foreign currency, the government has lost control of his debt burden; if his local currency devalues, it’s bad news bears.
• An interesting contrast, then.  Even with explicit repayment of government borrowings with newly-printed money (i.e. quantitative easing), the US and UK have rarely seen lower costs to borrow.  In contrast, Russia can’t get enough faith in their currency to keep the ruble alive: they need to intervene in foreign exchange markets to convince lenders that the ruble can and will stabilise in order to obtain debt financing for their government.  This is crucial, as with a low oil price Russia’s government has no hope of funding itself.  The US and UK have adopted almost the exact opposite (indeed, Switzerland adopted the exact opposite) approach: trying very hard to convince folks all the newly-printed money should cheapen their currencies, thereby stimulating demand.

In sum: the life of everyday Russians is getting worse and worse as their currency goes down the toilet.  Though the same problem could happen in the US or UK, in theory, the latter governments’ reliance on domestic-currency borrowings suggest nothing like the Russia situation in the foreseeable future.

From Cournot to Bertrand equilibria: OPEC giving discounts

Dusting off my old economics lessons, I recognised a couple concepts from today’s Bloomberg article on Iraq joining Saudi Arabia in giving oil price discounts.

In particular, oligopoly behaviour can frequently be modelled by quantity-based competition (Cournot, and old OPEC) or by price-based competition (Bertrand, and what we see today in OPEC).  The key point, as this Brown University lecture note states very well, is:

We conclude that in a Bertrand equilibrium, in the homogeneous good case, under the assumptions we have made, firms 1 and 2 will charge the same price, and the price will be equal to marginal cost. But this means that the duopoly market, in the Bertrand model with a homogeneous good, looks just like a competitive market. In particular, there is no inefficiency (no loss of social surplus) in the duopoly market. 

So go ahead and call up your local OPEC representative and thank him/her for providing a market-clearing, maximum efficiency price for oil consumers.  WTI oil has broken $63/barrel recently, which surely means $1.75/gallon gas for US drivers at some point??

More evidence of millennials’ economic headwinds

I’ve written before about the intergenerational issues associated with Social Security in the US.  Now I read more evidence of the millennial generation having lower real wages, thus leading to negative savings rates.  Not altogether surprising, with the higher level of student debt.

Where does this leave us?  A lot of software development jobs are required for all those indebted millennials…

Happy Friday!

Friday rant: Charles Schwab…wtf?

The previous few posts have been a bit heavy, so let’s change topics.  Today I read an open letter from Charles Schwab asking the Fed to raise rates ASAP.  His opinion is that retirees have been fleeced by the low rates, and are hurting to the detriment of the economy overall.  Statistics are offered aplenty, as Chuck applauds the return of normal monetary policy.

Sigh.  I’ve written about this a bit before.  A summary:

• The unconventional monetary policy wasn’t intended to redistribute from savers to borrowers, nor was it designed to hurt retirees.  The policy helped avoid catastrophic economic collapse, which would have hurt everyone.
• Savers (including yours truly) are disappointed with low interest rates.  Borrowers (including all those people now buying houses, so that house prices are back to pre-crisis levels) are very happy.  Though Chuck wants to focus on retirees’ marginal propensity to consume (i.e. they spend more than they earn), I would argue we’re about as well off with borrowers (who, by definition, spend more than they earn) having lower interest rates.
• Following the housing point: though it’s more common in the UK, there are probably a lot of US retirees relying on ‘trading down’ their housing to help fund retirement.  Thank the Fed’s low rates for high mortgage – and thus housing – affordability among younger homebuyers.  In this sense, the Fed saved retirees – not hurt them.
• Beware partial equilibrium analysis.  Higher interest rates better for the economy?  Really?  Yes, higher rates mean more interest received, but also means more interest paid.  In an environment where we want to encourage business investment and employment, higher interest rates are a bad thing.

In sum: this is the second letter written by Chuck that I have a serious issue with (the other one is this, which shows an absolute lack of information and analysis about high-frequency trading).  Why does the man insist on putting his name to such insanity??  I guess he’s getting some free press, even if it’s discouraging.

Happy weekend, everyone.

Let’s party like it’s 2007… Fannie and Freddie return to power

I was interested in this article by the Economist over the weekend.  In the latest ‘WTF?’ moment I’ve had when reading the financial/economic news, various US Government agencies have evidently removed the more stringent requirements on what qualifies as a government-guaranteed mortgage.  Remember the heady days of 2007 and before, when ‘stated income’ (a.k.a. ‘liar loans’) and < 5% deposit mortgages were the order of the day?  Welcome back, I guess.  In another ‘WTF’ moment, evidently banks no longer need to have ‘skin in the game’ for RMBS they’ve structured from Fannie/Freddie mortgages; they can go back to underwriting mortgages to whomever they please, confident Fannie/Freddie will guarantee the loans for structuring.  Again, back to the fun times!

The only somewhat relieving factor this time around is the US Government’s explicit ownership of Fannie and Freddie.  I mean, the Government/taxpayer were on the hook for the costs of mortgage blow-up in 2008; at least this time the taxpayer gets a 100% profit sweep.  It just makes explicit what has been common knowledge for a VERY long time: US taxpayers like people owning homes so much, they’re willing to subsidise each other’s purchases through the tax system.