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a blog from young economists at Nova SBE


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What the eye doesn’t see, the heart doesn’t grieve over

We are in the aftermath of the Portuguese local elections, nonetheless, our attention is already being needed for one of the major decisions at the country level: the Portuguese Government Budget (OE). Approximately one month separate us from the start of the discussion on the topic. So, in this article, I will recall one of the main debates around the first Budget of the current mandate: the shift in weight of direct taxes towards indirect taxes. The point I will be making is that 1) this change was likely perceived by citizens as a decrease in total taxes paid; 2) the substitutions of revenue from income taxes to consumption taxes decreased the overall distortion of the tax system; 3) the opinion I present in the previous point can also be corroborated by citizens feelings of fairness towards the tax they pay. Hence, this article is presented as food for thought as little (and quite ambiguous to attain) evidence exists.

On the discussion of the OE 2017, one of the main arguments by the opposition for the shift in tax nature, was that it would make the system less progressive. In other words, the government would be substituting a direct tax rate that is higher for the rich and lower for the poor, for an indirect tax that is the same for everyone and people only pay more if they consume more. In this article, we will disregard equity considerations and historical trends of economic variables, namely GDP which influences the tax burden measure (tax revenue divided by GDP), and focus on the public perception of the tax (assumed to be positively correlated with the distortionary power). This said, what happened in those years was that even though the tax revenue increased, public opinion seemed to be of approval of the lower income tax, ignoring taxation on products (indirect taxation).

In my opinion, there are two strong arguments to explain this acceptance rate. First, a lesser perception of the taxes which started to be hidden in the price of products and not well discriminated as in the difference between the gross and net salary. Important to notice that consumers’ perception of increases in price has many flaws, which reinforces why people will ignore the indirect tax. Secondly, considering people were not happy with the policies at the time, one can argue that income tax that people believed it would turn into erroneously spent government revenue was substituted by different consumption taxes pursuing objectives people could connect to, such as, tax on sugar, on cigarettes or pollution.

This shift may induce more support for government spending reducing tax aversion by citizens as defended by Listokin and Schizer, professors at Yale and Columbia Law Schools, respectively.

To conclude, the decision on taxes of the OE 2017, disregarding equity considerations seemed to be popular, what in the context of the current politics was determinant to win the confidence of the Portuguese taxpayer.

 

João Matias

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Enriching Lisbon while it sleeps

With the local Portuguese elections of 2017, a heated debate on the Lisbon touristic municipal tax incidence arose. This tax is decomposed into an overnight tax (a 1€ extra charge per night introduced in 2016 with a maximum of 7€, yielding 13.5M€) and an air and maritime arrival tax (introduced in 2015 only in the airport and materialized on a 1€ extra charge per arrival, yielding 3.8M€ and borne by ANA, which refused its prolongation to 2016). Basically, the arrival tax applies to all citizens except Lisbon residents, children under two years old and passengers having their connection flight in Lisbon and the overnight tax to every citizen above thirteen years old.

The effectiveness of the lodging tax has been recognized even by the political parties who voted against it. However, improvements can still be achieved. One discussed proposal is to increase the tax to 2€/night to guarantee more affordable housing opportunities, though its opponents defend that Lisbon cannot rely on the touristic tax to solve its structural problems. This critic seems reasonable because when taxes increase by 1% (perceived by consumers as a price increase), guests´ behavior may change (lodging demand elasticity) – empirical data shows a fall on the occupation rate. Nevertheless, the more inelastic the lodging demand (insensitive to tax increases), the higher the success probability of such policy.

If the local government´s objective is to increase the revenue levied by this tax, then two less obvious alternatives can be explored. Firstly, following Ancona´s (Italy) example, Lisbon´s city council could set a fixed tax independent of the accommodation´s length. Given an average stay in the capital of 2,36 nights and assuming no substantial future changes, setting a tax superior to 2,36€/person would expectedly generate a higher recipe. A possible critic here is the higher the number of nights spent in Lisbon, the higher the benefit acquired so discriminating the overnight tax according to benefit levels delivered to the tourist seems reasonable (benefits principle).

Secondly, note Paris´ example where lodging taxes vary according to the accommodation´s number of “stars”. Since hotels with five, four and three stars lodge most tourists in Lisbon, by setting a tax above 1€/per night for these accommodations and a lower tax for the remaining (tourism progressive taxation), the town hall could expect to increase overnight total tax revenue. Additionally, bearing in mind equity considerations, this proposal is justified by the typically higher predisposition to pay a superior tax of a tourist that stays in a three to five-star hotel than the one who stays in a hostel (diminishing marginal utility of income). However, this alternative presupposes not a fall on overall consumption but rather induce high spending tourist to “reduce only their savings”.

Personally, such tax makes absolute sense as to improve the quality of the city (not decrease the number of visitors), since the increase in Lisbon tourism is exerting higher pressure on existing resources. Accordingly, the proposed alternatives would be more efficient to achieve the desired goal while generating a higher revenue.

Margarida Castro Rego | 23848


Italian citizens are stuck in the gasoline puzzle

Since early 70’ Italian citizens have been suffering from one of the highest gasoline cost of the entire world and, after the powerful earthquake that hit the central region of the country one month ago, a new rise in the excise taxes on oil is considered almost sure by many opinion makers.

Compared with Germany and France, the major European economies, Italian gasoline’s cost for consumers is 10.7% greater: 1.31€/l for both German and French people versus 1.45€/l for Italians (data from http://www.GlobalPetrolPrices.com are referred to the 20th June-26th September 2016 period on a weekly basis). Such a high level in oil price is due to a fierce taxation system, mainly on the excise side. Nowadays, the Italian excise duty for leaded petrol product accounts for 0,7284€ per liter according to EY “2016 Global oil and gas tax guide”. Throughout Italian history, governments have used the excise on oil to collect money, easily and rapidly, in order to cope with exceptional circumstances or natural calamities or wars, too. For instance, taxpayers are still paying excise for the Ethiopia campaign of 1935.

On one hand, oil producers, who bear legally the excise, face no troubles in shifting the tax burden to gasoline users. On the other side, Italian consumers can hardly subtract themselves from this huge excise incidence. In fact, oil is Italy’s most important energy source (according to http://www.statista.com).

A possible explanation on this inelastic demand may rely on the inefficient infrastructures and transportation systems. Looking at OECD 2015 data, Italian investments in inland infrastructure, a key determinant of performance in the transport sector which include both spending on new transport construction and the improvement of the existing network, is only 0,40% of the GDP. This data is consistently low comparing to the 1% on the total GDP spent in a country as France, and to the German expenditure over GDP, which is around 0,60% (source: http://www.data.oecd.org).

Thus, when a new excise is introduced, consumers who use gasoline to reach their work place by car, could barely change their behaviour and start using an alternative mean of transport, like train, bus or metro. Perhaps those citizens who reside in metropolitan city, namely Milan and Rome, will start going to work with bicycle if there would be cozy and safe cycle paths developed as in Netherlands. Again, the main concern for Italians is a lack of substitution effect which could break up this stuck situation.

Focusing the attention on a long-term perspective, Italy 2015 investment level in renewables has been 33% less than German level (source: http://www.data.oecd.org) and the trend is steepening in the last three years. Nonetheless Italian investments in renewable sector is, quite surprisingly, the second one regarding the European Union, slightly higher than Sweden. So if Italian governments will do the necessary investments in both infrastructures and renewables, the next generations might be able to quit from the gasoline puzzle and, who knows, maybe excise duties on petrol will be used in a better way: as incentive to choose the “green way” in spite of polluted one, no more to raise money quickly.

 

Andrea Zilio


Environmental Tax Reform: A brief overview.

With the 20-20-20 target in mind, set by the European policy makers for the year 2020, it has never been of such importance for countries to discover ways to reduce pollution while not hurting their economy at the same time. In order to achieve the latter, the European Environment Agency (EEA) came with the idea of reforming the environmental taxation in countries which could consequently achieve a pollution reduction while improving other factors (social, economic,…) at the same time.

So what is an Environmental Tax Reform (ETR)?

An Environmental Tax Reform is by definition ‘a reform of the national taxation system where there is a shift of the burden of taxes from example labour/capital towards environmentally damaging activities such as unsustainable use of natural resources or pollution.’ In sum, with the measure, governments should lower taxes on production capital and raise taxes on activities that are harming the environment. This can be implemented in 3 different ways: First, governments of countries can carry out the ETR in a revenue-neutral way, i.e. leaving total taxes unchanged. Second, it can be carried out in a revenue-positive way, increasing the total tax burden and revenue for the government and third, in a revenue-negative way which is the case when not all taxes have been recycled. Although revenue-positive ETR sounds seductive for governments, it is however advisable to implement the reform in a neutral way, as it would be able to damage a country’s economy when taxes are already high and an additional tax would be levied. Now, how could an ETR ultimately benefit the economy?

A first effect one can describe is the one that the reform is designed to do: reducing environmental pollution. Companies will have an incentive to decrease their waste as to avoid taxes. Additionally, the ETR will have the effect of making various goods and activities (mostly bad for the environment) much more expensive as companies, who face additional taxes, will somehow pass on these cost to the end-consumer. Third, and most importantly, shifting taxes from labor to pollution may increase employment and promote ecological innovation. Why? Companies, after the implementation of ETR, will face less wage-costs and may therefore willing to create extra job opportunities within their organization. For example, a study by the EEA has shown that increasing the price of one tonne carbon dioxide to €68 by 2020 could create 152000 extra jobs in Germany.

A last important effect stems from the extra government funds available by increasing tax on polluting activities. The aforementioned funds could be used to create incentives for companies to commit to innovation such as the development of renewable energy sources and in this way boost eco-innovation.

In sum, environmental taxes have always had the misleading reputation of being an impediment to economic activity while in fact, as I’ve tried to point out in this blog, they can serve as an important and successful tool for boosting employment, innovation and a country’s economy as a whole.

 

Vincent Caudron


Should fertility be considered a public good?

Nowadays a huge debate is being discussed in Italy after the introduction of the “Fertility day”, promoted by the Health Minister Beatrice Lorenzin. This day was thought to stress public attention to the importance of fertility and to underline the danger of falling country birth rates. The reaction has been fierce, with many questioning if there may exist a better way to encourage people to have children.

Actually what has caused such an anger is not just the idea of procreation as a matter for the government to intervene in, but the images associated with women’s role, considered as sexist and ageist[1].

Despite moral criticism, it is important to see the question from an economic point of view. Are we sure that “fertility” should be considered as a public good?  Economists are used to refer to public good as a non-rivalrous and non-excludable item. It is basically a product that one individual can consume or enjoy without limiting its availability to any other individual. Public goods are, by definition, provided by the mean of government in order to avoid free riding issues. In that sense “fertility” is not a public good because there is no direct intervention from a central authority. Neither the intervention seems to be needed as a way to repair a market failure. There is no market failure in having too few children. Most people may agree that having a child is a very personal decision based on own values, circumstances and life or career goals. Some people want to have children, some do not, some might only want them later: all choices are equally logic. One may say that people are free to set their own level of children, even if it is zero, and that government should not intervene in this kind of decision. It should NOT, but it is forced to. Because low birth rate is a primary concern to government and to society as a whole. As a matter of fact, many countries are experiencing the problems of an ageing population and have taken measures to try to influence their birth rates since these affect pension system and standard of living[2]. If a country succeeds in setting an optimum level of population, then their people will have a better quality of life due to an increase in services, infrastructures, incomes. But there are still many implications on the public finance side. One of them is a redistribution issue: if maternity and housing benefits will be provided with taxation then people who are not keen on having a child (because they don’t want or they cannot) will subsidize the couples with a parenthood willingness. Another question would be: is it better to offer cash transfer in order to pay children stuff or to provide in kind services as healthcare and nursery? It’s clear that this phenomenon involves all of us, besides the weak economic framework that is triggering our society by a decade. Roughly speaking, the decision of having a child affects also the ones who do not.

Many weird proposals had been already thought such as giving a flyer about how to flirt (South Korea), divulgate fairytales (Japan) or invite couples to take a holiday (Denmark)[3] but in the meanwhile, population continues to age, affecting all welfare state and above all social security and pension system.

Thus “fertility” may be not a public good, but rather a public concern.

[1] https://www.theguardian.com/commentisfree/2016/sep/05/italys-fertility-day-posters-sexist-echoes-of-fascist-past

 

[2] http://www.oecdobserver.org/news/archivestory.php/aid/563/Can_governments_influence_population_growth_.html

 

[3] http://mentalfloss.com/article/33485/6-creative-ways-countries-have-tried-their-birth-rates

 


Social Security contributions – an active debate in public policy

Social Security is financed through contributions (SSC), in the form of payroll taxes. At an average of 9% of GDP in 2012, these are a significant part of the economy.

graph1Contributions are paid by both employers (paying the majority, at 5.1% of GDP in 2012) and employees (3.3%). These affect the labour market. Labour supply (SL) shifts upwards and becomes steeper, as workers compensate for taxation with a proportional rise in their reservation wages. Labour demand (SD) also contracts as the marginal cost of labour rises. This distortion in the labour market, illustrated diagrammatically, causes a reduction in the equilibrium quantity of labour (N to N’). Its effect on wages is (partially) supported by Saez et al. (2013) – earnings stay constant (Y=Y’) but net earnings fall (Y>Y’net).

This has led to its political characterisation as a ‘jobs tax’, accused of slowing job growth. This is predicted by theory – the employer not only needs to afford the worker’s wage, but also the social security contributions that come with hiring them.

For this reason, a reduction in the employer SSCs was included as part of Portugal’s structural adjustment programme. In 2011, several options were studied, from a general tax cut to sector-specific or new-job-exclusive cuts. In September 2012, the government proposed (and in the face of the largest protests since the revolution, abandoned) a policy of lowering the employer rate and raising the employee rate, with a net increase in contributions.

Portugal was not the only country where payroll taxes were reformed. Between 2011 and 2013, the United States implemented a payroll tax ‘holiday’ (which was really a temporary cut). During 2010, there was also an exemption for employers who hired unemployed workers.

These temporary tax breaks, however, do not address SSC’s labour market distortion in a permanent way. This issue has been addressed in the manifestos of Portugal’s 2 main parties, PS and PSD/CDS (PàF). Space does not allow a discussion of PàF’s Bush-likeprivatization‘ plans.

Portugal’s PS proposes a temporary break in employee rates (p. 11), hoping to correct the post-crisis hysteretical contraction in output and employment that has compromised Social Security solvency so. They innovate, though, in two proposals: one proposing discriminated employer SSC rates, rising with staff turnover (p. 33-4), and another in proposing a replacement of 4% in employer’s SSCs with a consignment from corporation tax (ibid, p. 43-4).

This diversification of social security financing will represent a net saving for most firms, particularly for labour-intensive sectors who paid a larger share of their revenue in wages and so payroll taxes. Portugal specialised in many of these labour-intensive sectors (cf Mamede 2015) and these have been some of the most hit by the crisis and austerity – e.g. construction and restaurants.

This policy is therefore targeted for maximum stimulus. However, research tells us economic development comes from capital-intensive growth outpacing labour-intensive growth. This, indeed, has been the development strategy of previous Socialist governments, which suggests PS’ policy innovators still have some fine-tuning to do to maximize growth as well as stimulus. After all, only growth can really secure sustainability.

Miguel Costa Matos


How to nudge people towards better choices

“If you want to get somebody to do something, make it easy. If you want to get people to eat healthier foods, then put healthier foods in the cafeteria, and make them easier to find, and make them taste better. So in every meeting I say, “Make it easy.” It’s kind of obvious, but it’s also easy to miss.” (Richard Thaler)

Although the economic theory assumes that individuals make their choices based on expected utility, the reality shows that we often tend to make choices that go against what our real intentions are. The lack of information and the complexity of events do not always allow us to be perfectly rational.

By maximizing utility, or making optimal choices, individuals can improve the overall welfare of the society. Therefore, the government is incentivized to induce individuals to follow certain behaviours. To do so, the government can intervene through taxation or subsidies, and in this way influence the final choice of the individual by making a good more or less desirable. However, by doing this, the government forces citizens to behave in a certain way, limiting to some extent their personal freedom.

Nudging is a possible alternative way for the government to influence people’s behaviour without being intrusive. A nudge is a policy that helps you to behave the way you probably would if you were better disciplined and better informed. But it does not force you to do so. A nudge is not a shove. It does not compel you to do anything.

Some experiments have explored how effective nudging can be when it comes to solve social issues. One example is the donation of organs. The rate of donors is known to be significantly low in many countries. It is largely demonstrated that countries with an opt-out system have higher percentages of donation compared to opt-in countries. Germany, which requires people to explicitly state their willingness to donate organs, has a rate of donors of 12 % of total population. This can be compared to Austria, which adopts an opt-out system of presumed consent, has a donor percentage of 99 %.

What we see is that, generally, a great share of the population is in favour of organs donation but only a very small percentage takes the decision to join the donors’ register. Be it for inertia, or for lack of information or interest in the issue, if individuals are not encouraged to face the choice they tend to avoid it. As the idea of a general mandated choice, might not be accepted by everyone, there are other possible ways to influence people’s behaviour. In 2006, a plan, able to gather 2.3 million donors, was implemented in Illinois. The idea was that whenever someone was renewing his or hers driving licence the person was given the opportunity to choose to become an organ donor. This increased the rate of donors from 38 % to 60 %. Today, the government of Illinois allows citizens to spontaneously become organ donors simply by registering online.

This example shows that governments can effectively influence the behaviour of people by nudging them to take decisions that are likely to save someone’s life and more importantly without coercing anyone. Nudges can be seen as a tool that complements public policies rather than substituting them and when used to direct individuals to take the most preferable decision then the overall society will benefit.

Reference:

Thaler, Richard H, and Cass R Sunstein. 2008. Nudge: Improving decisions about health, wealth, and happiness. Yale University Press.

Giulia Casagrande, 745


Democratic Game

Revealed Preferences & Distortions on Public Choice

Voting is the most sensible expression of social will. It enables people to decide and reveal preferences about politicians’ acts, policies’ effects and different levels of public intervention. This post pretends to link some crucial concepts that we study in Microeconomics course, explain why sometimes democracy gives unexpected results and how important are the assumptions of revealed and well-behaved preferences.

Combining equity problems, behavioural distortions and market failures, the Public Choice analysis is one of the most challenging economic exercises which considers an interaction of three different levels:

  • Individuals who have preferences and want to maximize their welfare through public and private consumption (considering a budget constraint in which taxes are included as the indirect counterpart from public provision).
  • The Social Institutions that want to maximize Social Welfare and find an equilibrium, which can be different from the individual optimal solution.
  • Politicians, more benevolent or more selfish, who want to be infinitely re-elected by pleasing their voters (who can punish politicians if they deviate).

Although each politician has its own ideology and ethical belief, economists have tried to find a way to explain people’s desires and performances in the electoral game The rules are simple: citizens have different needs and they are willing to pay for welfare. However, payers and beneficiaries are seldom the same, moreover, free riders and externalities insist on stiffening our problem, which may lead to under-provision.

The most difficult analysis is to reveal preferences and to aggregate them in order to define the most important function, which tells us what people need and how they value it. In the real world, it is completely impossible to design a beautiful utility function or continuous indifference curves, linking bundles with the same value for citizens. Therefore, governments may ask voters to define their preferences (and the easiest way to do so is) by ranking bundles or options with the help of public surveys or referendums. Actually, politicians have the incentive to reveal citizen’s preferences in order to prepare persuasive speeches and move themselves to a good place in the Downs Avenue.

Nevertheless, even if we could solve all these problems and know exactly the marginal value of public provision for all individuals, democracy would still have distortions sorting out electoral choices and ‘right choices’. Therefore, it is relevant to present the most famous Electoral Paradoxes and their contradictory results:

Condorcet’s Paradox, the most popular of all, presents a situation in which a majority election over pairs of alternatives may have no clear winner. Suppose that A, B and C are possible choices and each voter orders his preferences as the following:

Captura de ecrã 2013-10-19, às 06.23.58

After beating the first winner (A), C becomes the final winner. However, would this result be the same if the fist election opposed A and C? No, because C would be the first winner and would lose against B (1+2 vs 3). In the Condorcet’s Election, the Voting Agenda determines the result (the winner is always the last voted choice).

Ostragorki’s Paradox involves the role of political parties as mediators of Public Choice. Supposing two parties (X and Y) and each individual voting for the party whose position is closest to his own:

Captura de ecrã 2013-10-19, às 06.24.06

Issue-by-issue, party X would win on every subject. However, if people choose parties to represent them, a majority of voters will elect party Y. This paradox presents one of the failures of the representativeness of parties.

The Additional Support Paradox considers strategic voting (of 21 voters) in a majority runoff election (the winner must have 11 votes, otherwise there is a second round between the two most voted).

Captura de ecrã 2013-10-19, às 06.24.14

In the first election, there is no absolute majority. Then, a runoff is held between choices B and C. It is easy to conclude that the winner is B (13 – 8).

Now, imagine that B receives the additional support from three ‘C-voters’. Still, we have no majority and the runoff will oppose choices A and B. Now, the final winner is A (11 – 10), despite of the additional support B has received.

When we think about Democracy, we will find many imperfections such as preference revelation problems, free-riding effects, electoral paradoxes, imperfect information problems, crowd psychological effects and general lack of trust on politicians. However, more than failures, these are challenges to solve with perseverance and always keeping in mind Winston Churchill’s words:

“Democracy is the worst form of government, except for all those other forms that have been tried from time to time.”

Dino Alves  # 607


Tips and Taxes

As described in detail by Andrew Schotter (79), tipping is a social convention with economic value. In this comment, I intend to give a brief explanation of the economic gains from this institution and then, in the line of my previous post, present its cost, namely its tax implication.

Whenever regulating the exchange of otherwise trivial services (such as haircuts, meals, etc) would involve negotiating and writing excessively long and costly contracts between client and performer, tipping, by allowing  variable compensation that rewards quality, comes on its own by avoiding these high transaction costs.

For example, when entering a restaurant, it is neither feasible nor cost-effective to design and enforce a contract specifying unambiguously all the conditions of the deal (how many (and how tasty) french fries will be served, the gentleness of the waiter, the quality of the glasses and cutlery, etc). So, except for some characteristics (namely sanitary and safety conditions) that are regulated, we are unsure about the food and the quality of the service we will receive -and because there is no contract, there is no way of litigation either. However, if tipping is instituted (i.e. the waiter expects it and I feel bound to tip if satisfied) there is less need for the extensive contract because both parties implicitly agree that a fixed part of the meal cost will be paid in any case but that the other, the tip, will vary according to the client’s level of satisfaction. In the case of dissatisfaction, the client simply does not tip or pays a smaller tip (and usually does not look for further recrimination). Conversely, the waiter expects to be rewarded for good service.

Furthermore, tipping is an efficient mechanism for the allocation of workers as it promotes self-selection. Again, in the restaurant industry, because of information asymmetries, the employers cannot really be certain of each applicant’s abilities at the moment of hiring. However, setting a payment system consisting of a fixed wage plus a variable component (the tips collected), will dissuade bad waiters from applying, as they know they won’t be able to collect tips enough to cover equal their opportunity wage. On the contrary, good waiters will be keen to accept those jobs, as they know they will receive lots of tips.

So, we conclude tipping is in fact advantageous for the satisfaction of multiple parties in the economy and that it contributes towards efficiency. However, tipping comes at a cost too!

Following my previous comment on the possible decrease of the VAT for the restaurant sector, we can also identify another advantage of restaurants over similar businesses: tips are not taxed! Clearly, if tipping allows for lower prices (as part of the service cost varies according to the client’s satisfaction, and is only paid after the issuance of receipts) then it is reducing the base for VAT, especially when the waiter service is a major part of the added-valued of restaurants. But this does not end here: restaurant owners also pay lower IRS, (tax on income), on behalf of the waiter since this amount is calculated taking into consideration the fixed part of the wage alone. Similarly, lower contributions to social security are paid.

Then, if tipping reduces the amounts of all three taxes paid by restaurants, on top of their known ease of evading taxes (they merely have to declare stocks as having expired), we clearly observe an unfair advantage over similar businesses, namely those who compete for the same workforce but where there is typically no tipping (for instance, shop sales staff: identically not well-qualified but not tipped for their services). This tells us that the real VAT rate restaurants pay is in fact lower and further justifies the previous argument that lowering the VAT for restaurants only is conceding an unfair rent.

Moreover, if we say that, with the present crisis, tipping rates fell (as consumers try to cut spending to minimums), the unemployment increase in the sector cannot be fully explained by the increase in VAT that occurred in 2011.  As tips fell, some waiters left their jobs or demanded higher fixed compensations; this may have led to the closure of many restaurants whose service quality deteriorated or who could not afford higher costs. So, the impact of lowering VAT as proposed by the government will probably be even smaller.

From another perspective, we can look at tipping as an adjustment factor that allowed restaurants not to dismiss employees. After the VAT increase, people knew they had to keep paying tips as long as they were interested in maintaining the previous service quality level (this may be plausible if we believe that the number of employees per restaurant did not decrease much, in this case unemployment is mainly explained by the full closure of many restaurants).

Matilde de Vasconcellos 666


Too early for lunch?

In Portugal, on January 1 2012, VAT on restaurants, bars and cafes rose to 23%. The Government’s intention was clear: raising fiscal revenue. At the end of the year, results were out: an 109% increase in fiscal revenue from the sector (€521 million for 2012). However, a large share of the additional revenue results from stronger fiscal control.

Now Government is considering cutting the rate back to 13%. This time, the argument is that the decrease in the tax rate will act as a favorable stimulus to the short-term creation of jobs particularly effective for the younger workers who face the highest unemployment rate. Unemployment is indeed a concern in the sector: according to INE, in 2012, the number of unemployed people with origin in the restaurant sector increased by around 7.800, adding to the total observed number in 2011 of 55.565 individuals. In 2013, the figure increased even further, although at a lower rate.

How plausible is this?

When VAT went up, from 13% to 23% (77% increase!), prices were expected to increase similarly. But, checking the CPI for 2012, the true price increase from dec2011 to dec2012 in restaurants, cafes and similar services was only 1,35%.

So, it is reasonable to conclude that the added VAT was paid out of restaurant’s margins and not from consumer’s pockets. As demand for restaurant services is very elastic (meals-out are easily substituted by doing-it-yourself),  restaurants were probably afraid that passing the tax burden to their customers would lead to a very large drop in demanded quantity (already low due to recession and low available income) and absorbed it themselves.

As VAT is an AdValorem tax on the producer, a change in the tax rate causes a pivotal shift in the supply curve. In the left graph, contraction in demand is assumed and, the new tax revenue of 2012 is shown, as well as the maintenance of prices. In right graph, tax revenue for 2013 is given by Q´ (where S’ (VAT=13%) meats D´) times the (equilibrium price-willingness to sell Q´ at S(VAT=0%). The price fall consequent to IVA drop is small – unfortunately no comments can be made on the exact size of final tax revenue impact, as it depends the proportion of Q and P changes .

Image

There is empirical evidence that VAT changes on restaurant services are only partially reflected on the market price (i.e. in 2009 France restaurant VAT fell from 19,5% to 5,5% but restaurant prices decreased by no more than 1.1%). In Portugal, a Trade Association already stated that prices will not go down -hence there will be no “boost in demand” and restaurants maybe actually gaining profits unfairly, “a rent”, when compared to other firms. Additionally, as restaurants are prone to tax evasion, and in spite of supervision tightening up, they may still be benefiting from a “real VAT” lower than other sectors firms. Furthermore, it does not seem very likely that the tax decrease will allow for any relevant increase in employment of the low-skilled workers of the sector as firms claim they are near the shut-down point. And there may even be the case where each job created will represent an unjustifiably high cost for the public finances (as occurred in France’s VAT cut of 2009 where each job generated came at a cost of €120.000 1). Finally, Government favoring restaurants over similar businesses that use the same workforce, may end up causing distortions in the labor market.  Government may be keen on introducing some alleviating measures, as an answer to political pressures or to sustain the expectations that “the crisis and is almost over”, but isn’t the expected liquid revenue loss of 50 to 100 million€, immediately after the end of the External Assistance Program, a little too much?

1 – Sénate, La TVA à taux réduit dans la restauration: une mesure qui fait ses preuves.

Matilde de Vasconcellos 666


A Flat and Unequal World

There was a time when the world was enormous, spanning the almost infinite boundaries of each closed country. In that time, trade was a challenge just for the bravest men who were able to face the unknown. Until the Fifteenth Century societies thought that the world was flat, that was when Columbus discovered how wrong they were. From then on, this round world has never been the same and all these technological advances strengthened the idea of the death of distance.

As a result of Globalization, most economies are linked by the crucial role International Trade plays in our lives. Thomas Friedman declares in his book “The World is Flat”, which doesn’t pretend to contradict geographical beliefs only stresses the decreasing role of distance on our modern economy.

Edward Leaman’s review of this book highlights an interesting point hidden behind the benefits of trade. By comparison to autarky, international trade does provide welfare gains, however, it means specialization with strong changes in the productive structure inside each country. In other words, some people will win and some will loose. Professor Adrian Wood presented this concept beautifully in his case study regarding North-South Trade and the effect on the labour market across different countries.

The central message of the Heckscher-Ohlin Theory is that countries tend to export goods whose production is relatively intensive in factors with which they are relatively abundantly endowed. Stolper-Samuelson theorem also states that opening to international trade, holding factor supplies constant, increases the real return of the factor used intensively in the production of exported goods, while lowering the real return to the other factor. The simple and relevant conclusion is that owners of a country’s abundant factors tend to gain from trade; meanwhile owners of a country’s scarce factors tend to lose.

Despite the well-known rigidities, this reasoning may be applied to the labour market considering high-skilled and low-skilled workers. According to theory, international trade would increase high-skilled real-wages in developed countries (who have high-skilled labour as the most abundant factor), while it decreases the low-skilled real-wages. By contrast, trade should decrease wage inequalities in developing countries, where high-skilled labour is relatively scarcer. The following graph presents some data about openness to trade and income inequality for low-skilled countries and high-skilled countries.

Trade & Inequality

There is some work relating trade liberalization policies and labour market changes and the answers remains unclear. There are two interesting papers trying to analyse this question: the first is about the 1991 Indian trade liberalization and the second about the impact of Chinese growing import competition on the U.S. labour market.

Empirically, it seems that international competition causes strong changes in both productive structures but it’s not enough to explain the reduction of poverty in India or the increase in U.S. inequalities. The case of India showed significant differences in poverty reduction across regions depending on their characteristics (if each region is more or less rural). The second paper demonstrated that import competition explains only one-quarter of the contemporaneous aggregate decline in U.S. manufacturing employment (while transfer benefits payments for unemployment, disability, retirement and healthcare reforms are the most relevant factors).

These adverse side effects have significantly increased unemployment, inequality, poverty and other forms of social erosion (as organized crime) at low-skilled activities and some developed countries are tempted to raise protectionist barriers. This is the worst possible response that governments may implement because it decreases welfare in both countries and creates deadweight losses. Rather, governments should implement long-term policies, such as investing on human capital or improving the educational system so that low-skilled workers can attain higher qualification levels and benefit from trade instead of being harmed by it.

This is the most efficient way to support the economic pattern transformation without the social and welfare costs that international trade usually creates.

Dino Alves #607


Oh, you think tax havens are good for the economy?

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Source: http://www.abendblatt.de/img/sport/crop105734922/1160693625-ci3x2l-h307/bayern-HA-Sport-Muenchen.jpg

Watching the video of the Center for Freedom and Prosperity on „Why tax havens are good for the global economy“ http://www.youtube.com/watch?v=yi0lkJBTi58, I, after taking a course in Public Economics, was quite shocked that it even is possible to claim a ‘scientific’ linkage between the economic performance since the 1970s and the existence of tax havens.
I got quickly suspicious of how the narrator was quoting reports and research papers on the issue of tax havens and tax competition. The main trick, in my view, is that tax competition is sold as being exactly the same thing as setting a framework for tax evasion.
The OECD is mentioned as the penitent bureaucracy which admits that „the ability to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively“http://www.oecd.org/eco/outlook/2088806.pdf. However, this citation is clearly taken out of the context, presented in a way that fits the Center’s objective. In the OECD’s report on „Forces shaping tax policy“, the sentence appears in the context of a geographical mobile tax base (p.10) and is followed by the insight that a too high downward pressure on tax rates eventually would lead to a too low governmental revenue raised.
Moreover, after having identified several efficiency problems with high tax rates, the OECD states that the main objective has to be to minimize distortions while governments still are able to raise the needed funds, and points out, that threats like a mobile tax base rather have to be faced by international coherent practices. The OECD is concerned that „It is increasingly difficult for individual countries to manage their tax bases in the face of these forces and, in particular, some tax practices have led to harmful and distorted cross-border ‘tax competition’“ (p.13).
So, I would definitely not say, that the OECD now is in favor of tax havens or tax laws that are harming other countries in raising the revenue that is needed.

The statement that tax havens „promote good policy around the world“, I have to comment on.
Tax competition may be good in a model set-up of Leviathan governments as they would lead to a more disciplined usage tax revenues. However, political accountability is worsened, and hence, the overall effect is ambiguous.
And how to define good policy? Ain’t it be the case that tax rates are set in such a way that they generate the country specific revenue income? Because, I would claim, that this revenue level is distinct in every nation, depending on the coverage and degree of social services provided by the state and the demographic composition, implicitly being a reason for why tax rates never will nor shall be the same.
Also the claim that „tax havens generate high living standards. Grow faster and create more prosperity“ was proofed wrong with the case of Cyprus.

One general remark on tax evasion – the illegal form of tax avoidance – which I do conceptualize with tax havens, not tax competition: At the time, there is a debate going on in Germany on the legal treatment of tax evaders that report themselves to fiscal authorities.
Having in mind that one aim of taxes is to redistribute income between groups – fairness in society – I do not see any benefit for the global economy, welfare or equity improvements when better-off individuals park their money in Switzerland. Cause the milliards of euros that are hidden from the fiscus thus have to be generated by the rest of the population – to call it a peccadillo is just outrageous.

Christiane Seidl


Krugman – Don’t let him be misunderstood

With “Taxing Job Creators”1, he picks up the dispute of Democrats and Republicans when it comes regarding taxation of top-earners.

Reading through the comments left me in total confusion – Is it possible that a Nobel Prize winner is missing points of Economics 101? Not few did criticize him, and yet, though hidden in a camouflaged mocking of conservatives, he has a point, and an important one, I would claim.

 

Krugman, being a liberal himself,  is focusing on the political arguments of rightists; two common ones (expropriation and responses at the intensive margin) he considers as being dull, but the last – “You’ll kill job creation!” – seems interesting to him.

He argues, by referring to a paper of Diamond and Saez (D&S), that the marginal tax rate at the top should lie around 70% – but the main purpose of the short article is to challenge the conservatives’ justification of keeping the tax rates low: claiming their arguments to be rooted in the concepts of free-markets, he argues, is ignorant, since it is not embedded in the theory at all. Indeed, his last sentence does capture his point perfectly: “Even if you believe that the top 1% or better yet the top 0.1% are actually earning the money they make, what they contribute is what they get, and they deserve no special solicitude.” Meaning, that what they create already is measured by what they contribute to GDP – the rich are not the job-creators, and for that reason they should not be treated differently; the reasoning behind is easily grasped: there is no direct income effect on other individuals when you choose to work one hour more or less. And this is always true.

Many did attack Krugman for not taking into account multiplier effects, but I think they are not relevant for what he is trying to tell us. Even though the rich do send a bigger paycheck to the government, at the margin, any person of any income group, is equalizing benefits and costs. So, the principles of free-markets can never justify subsidization (= lower marginal taxes). Recall, the real effect is caused by an eminent substitution effect at the kink of the budget constraint where a higher marginal tax rate  causes government revenues to shrink. However, the effect is assumed to be quite low for the top of the top, implying that overall revenues will increase.

Taxation is the government’s tool to redistribute, and if it really is like D&S suggest – 1$ to the government contributes more to society’s welfare than if that dollar is consumed by a top-earner – there is no plausible reason to not try to maximize the revenue that can be collected from that group. The only constraint is set by balancing the trade-off of marginal gains in revenue and rising distortion due to taxation2.

 

To close the circle, exactly that trade-off is why the optimal tax-rate on high incomes should be lower than 100% – but, there is no space for arguments totally unconnected with basic theory of public economics.

 

 

Written by: Christiane Seidl

 

 

1Krugman, Paul. 2011.Taxing Job Creators, The Conscience of a Liberal. The New York Times. The Opinion Pages. http://krugman.blogs.nytimes.com/2011/11/22/taxing-job-creators/ (visited 02.04.2013)

2Diamond, Peter and Emmanuel Saez. 2011. The Case for a Progressive Tax: From Basic Research to Policy Recommendations. Journal of Economic Perspectives, Vol.25 (4), p. 165-190. http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.25.4.165


Is the diffusion of low-cost flights a modern manifestation of tragedy of the commons?

The emission of greenhouse gases not only is a modern tragedy of the commons but extents its effect over space and time. The lack of a supranational regulating institution makes it particularly difficult to tackle the problem.

The purpose of this report is twofold: Firstly, an analysis on whether low-cost flights are a modern day manifestation of tragedy of the commons and secondly, if the answer to the previous question turns out to be positive, to propose an appropriate policy intervention mechanism.

Table 1 shows a comparison of ticket prices and pollution levels of three different means of transports on the track Rome – Venice (the data is provided by ENEA, the Italian national agency for technological development and energy). The respective ticket prices were then augmented by the cost of emissions they produce. The latter is calculated as the product of units of emissions times the carbon price (Futures on EU Carbon Allowances 3rd Period which mature Mid December 2012, source: Bloomberg BNEF).

Table 1

Track “Rome – Venice”

Low-cost airline

Train

Car

Price

€ 39.07[1]

€ 49[2]

€ 95.71[3]

CO2 emissions

104 kg

26 kg

52 kg

Carbon price per kg

€ 0.01130

Cost of emissions

1.18

0.29

0.59

“True” ticket price

40.24

49.29

96.3

 

The comparison shows that, even if emission costs are included, the price of low-cost airlines is still below the price of trains and cars. Given the size of the difference between the actual and the “true” ticket price, we can assume that also current prices are close to economic efficiency. The distortion they cause to people’s decision making is minor and also the size of the excess pollution caused to the environment by airplanes because of inappropriate price setting is marginal. In any case, considering that plane rides are both, the fastest and the cheapest alternative, there won’t be any change in the preference ranking of a rational decision maker. In fact, only a carbon price of 98.34 per ton would make trains and planes competitive. This is very closed to 100, the fixed upper ceiling of the carbon price, which has never been achieved yet.[4]

It is, however, important to eliminate this price distortion to achieve an efficient economic outcome. Emissions bring in fact both, economic benefits in terms of production, but also environmental damage through pollution. The goal is therefore to find the socially optimal pollution level as a compromise of the two: This will be at the point where the marginal benefit equals the marginal damage. A tax[5] per unit of carbon emission equal to the market carbon price (0.0113/kg) is appropriate to approximate the marginal damage of pollution. It is a cost-effective instrument, doesn’t require much information except from the price of carbon allowances but only needs to be adapted in case of inflation and economic growth. Society would benefits in two ways: trough the increase in tax revenues and through a less polluted environment.

 

Nadja Mumelter


[1] Easyjet is the only low-cost airline operating on this route

[2] Tariffs according to Trenitalia www.trenitalia.it from Roma Termini to Venezia Mestre

[3] Calculated by Via Michelin, including fuel and toll expenses

[4] Alexander Brauneis, Roland Mestel, Stefan Palan, „Does a cap on the carbon price have to be a cap on green investments?“, 02/2012

[5] Note, that this is not a Pigouvian tax since the requirement of knowing the socially optimal level of emissions is not satisfied.


Pollution problem in central Lisbon: imposing a tax or restricting access?

When individuals impose costs on others, without having any economic incentive to take those costs into account, we are in the presence of a negative externality. As explained by the economic theory, externalities may lead to individual decisions that are not optimal from the point of view of society as a whole. Without any intervention, the market will tend to overproduce negative externalities.

Air pollution is often presented as a classical example of a negative externality. In recent years, we have been confronted by the media with some news pointing out pollution problems in central Lisbon and claiming urgency towards action. Avenida da Liberdade, a key point for those who enter or leave the capital by car, is today one of the most polluted avenues in Europe. Several times, the legal admissible levels of air pollution were exceeded. In this context, not respecting the EU Directive of Air Quality might have severe consequences, especially when Portugal is under external assistance and so financially constrained. Would we like to pay a fine of 1.9 Million Euros plus 630 Euros per day until compliance with the EU Directive?

Furthermore, the problem is even worse due to the daily traffic congestion during rush hours. As we know, urban traffic congestion is a modern example of a “tragedy of the commons”. If we consider the trips by car along the Avenue as a good, immediately, we will agree on its non-excludable nature. However, since there is free access, there will be rivalry in consumption, that is, the access creates scarcity of space and thus congestion. 

How should this problem be addressed? As a science, Economics can offer its contribution. Indeed, from very simple models, we can extract powerful insights. The 2012 Prize for Shapley and Roth clearly demonstrates the growing acknowledgment for the use of abstract theory to ongoing efforts to find practical solutions to real-world problems.

We decided to use a simple model with marginal benefits and marginal costs. The model incorporates both pollution and congestion problems. We have assumed that there is demand for a certain good Q, which will represent the number of trips by car along the Avenue. The cost structure has two major components: (1) private costs, including costs related to car use such as fuel and maintenance, and also time costs derived from traffic congestion that drivers partially take into account; (2) external costs, which include all those costs that drivers impose on others and that they have no economic incentives to take into account (e.g. reduced air quality, increased level of noise and higher risk of certain diseases, as well as the external portion of congestion that is not internalized). The sum of private with external costs gives the social cost function.

We have assumed that until QA there is enough environmental assimilative capacity to absorb the emissions associated with the number of trips in the Avenue, and that congestion only starts after that level. In other words, below QA there are no external costs to society (no pollution and no congestion problems), but only the private costs to drivers, which we considered as constant. Then, after QA, the marginal private cost function (MCp) becomes increasing due to the portion of time costs internalized by the drivers. Additionally, after that level, the number of trips along the Avenue starts causing external damages to the society: congestion not internalized (cong) and air pollution (e). It is important to note that in our setting, we have assumed complete independence between the damages of congestion and the damages of pollution. In practice, it is plausible that there is a relationship between these two functions, which would further complicate the analysis of the problem. Here follows the graphical analysis (the Q-axis is normalized):

The optimal number of trips in the Avenue is given by Q*, where marginal social costs (MCs) equal marginal benefits (MB). At that point, from a social perspective, there are no economic incentives to increase or decrease the number of trips. Obviously, if doing nothing is a possibility, drivers will freely choose Q0, where they are minimizing their private costs.

From our simple setting, we will be able to analyze, from an economic perspective, two alternative policies to solve the pollution problem.

The first one, which is already implemented by municipal authorities, consists in changing traffic laws in a way that access is restricted. Due to restriction of access, the number of trips that starts causing congestion will be lower than QA and marginal private cost will become an increasing function after that level. However, restriction of access will change the social optimum. Since the government is trying to solve the pollution externality by restricting the access to the Avenue, in reality, it is creating a bigger problem by correcting one externality aggravating the other. Now, as traffic starts congesting at an earlier stage, the new social optimum will be lower than Q*.

An alternative policy would be the imposition of a congestion charge, covering a vaster area in the center of Lisbon (including the Avenue), similar to the one already implemented in London since 2003 (for further details: www.cclondon.com). Theoretically, that charge would be a Pigouvian tax, which is, by definition, a unitary tax equal to the difference between marginal social costs and marginal private costs at the optimum. While raising revenue through the implementation of this tax, authorities force drivers to internalize the damages that were previously not taken into account. The net losses associated with higher private costs due to traffic congestion are now a net transfer of welfare from drivers to the government.

Both policies attain the objective of reducing the number of trips. However, restricting access to the Avenue leads to an inefficient outcome, since those losses incurred by drivers are not appropriated by the government. On the other hand, a Pigouvian tax will lead to an efficient outcome as it maximizes net benefits from a social perspective, that is, we will reach Q* again. Additionally, this measure will not aggravate the existing externalities.

In conclusion, our example illustrates the distinction between an efficient policy and a feasible one. While it is efficient to apply a Pigouvian tax, it might not be practical, since it imposes a higher burden to drivers than restriction of access.

Tiago Silva

Nuno Salva

Yan Yang