Monday, September 22, 2008


In Sunday, voters in my native Slovenia elected left-leaning political party that will presumably hold the majority in the national parliament, given favorable majority conditions for left-leaning political parties as well as the distribution of votes and preferences of political agents. Political analysts and comments have said that Slovenian voters now turned to the left. Aside from political populism of welfare state, it is time for a brief economic view on the future of Slovenian economy and consequences that left-leaning economic policy may induce.

Some Facts about Growth

In 2007 and 2008, the output of Slovenian economy grew by historically high rates, averaging around 6 percent. Economists have different views and analytical opinion what pushed growth onto such high rate. One group of economists believe that output increase is a consequence of demand boost through government spending on infrastructure that boosted economic growth, bringing demand-pull inflation as a consequence while another group of economists believe that Slovenia's economic growth is a result of higher investment rates, favorable global economic conditions such as lowering interest rate and tax cuts. After reviewing the data and forecasting assumptions, I analytically believe that the phenomena of economic growth in recent years in Slovenia has mainly been the outcome of robust investment, reductions in marginal tax rates on labor and capital, and low interest rate. However, given the state of low interest rate, capital deepening is not a key to aggregate productivity growth. What Slovenian economy experieneced was surging investment and small supply-side tax cuts that boosted output growth. In the long run, the growth of productivity is essential to economic growth. Without it, the output growth would slowly diminish in relative terms since a continious lowering of interest rate would lead to deflation trap such as experienced by Japan in 1990s. As first, I would like to refer to the pioneering work of professor Moses Abramovitz on economic growth and output trends (here, here and here). Professor found out that there are huge growth residuals in the measurement of economic growth. For example, when the emergence of new economy propelled innovation, the latter was perceived as an exogenous shock, leaving a huge part of economic growth unexplained. While the static measurement of growth was an empirical practice as long as measuring samples of output growth were based on simplified input assumptions, dynamic advancement of innovation into production, at first, seemed as a measure that is decreasing productivity growth. However, productivity paradox revealed that assumptions in the measurement of economic growth are not a static experiment but rather an experiment that needed empirical renewal. Today, we measure economic growth through endogenous growth model where engines of growth do not come from the "outside" (exogenously) but from the "inside" (endogenously). An advantage of the endogenous model of growth is that, in general, there are not many residuals since shocks are already entailed into the model of growth. However, economic policy can significantly affect the economic performance over the future horizon.

The Greed of Political Agents

In the political market, political parties are utility-maximizing agents that seek anticipated rents through time and power they aim to achieve in the political arena. Therefore, their existence depends entirely on the distribution of economically absurd promises to different interest groups and stakeholders. In Slovenia's pre-election period, political parties delivered countless promises about the prospects of economic development, inflation and other economic issues. If there's a widespread virus of economic illiteracy, then the ideas such as "inflation is a fiscal phenomena" and "government is to be blamed for poverty" can really stick to the conventional wisdom.

Economic Scoreboard

In the fiscal year 2006-2007, the Ministry of Finance launched the first tax reform in the history of independent Slovenia. Top tax rate on personal income was reduced from 50 percent to 41 percent. Also, the entire tax code was gradually reduced from 5 tax brackets to 3 tax brackets with progressive income tax structure - 16 percent, 27 percent and 41 percent. Although tax burden remained high, consuming approximately 47 percent of the GDP, there was an intial supply-side effect on jobs, investment and tax revenue that reached historic highs after tax reductions were imposed. Also, budget deficit (in percent of the GDP) has been reduced and public spending (in GDP's share) reduced as well. Some economists blame tax reductions for poverty. In Slovenia, there is a wrong perception of poverty. The latter cannot be defined by confusing income and net wealth. Using Gini coefficients, the income inequality in Slovenia is among the lowest in the EU, just behind Sweden and Denmark. Also, using Eurostat data (here) as an analytical source, the risk of poverty in Slovenia is among the lowest in the world. Also, Slovenians owe the highest share of owned tangible households in the world. Thus, the rate of poverty in Slovenia is approximately 3 percent of the individuals above the age of 15. In the last four years, the rate of economic growth reached historic highs. Even though Slovenia is a transition economy, output growth throughout transition period was among the lowest in Eastern Europe. However, in the last four years, output growth exceeded 5 percent; the most rapid economic expansion in the economic history of independent Slovenia. Unemployment shrank sharply with its natural rate averaging 4 percent. Although "higher wages" are a popular manifest nowdays, it must be recognized that, in the long run, wages and productivity correlate. In the short run, it is evident that wage growth is behind the productivity growth. Recently published data by the Eurostat have shown that Slovenian economy has not completed the convergence of productivity relative to EU27. Today's level of real labor productivity in Slovenia is 84 percent of the EU27 level, and between 60 and 70 percent of the EU15. Estonia is the regional leader in productivity convergence from 1997-2008, while Slovenia is a regional laggard. From 1997 to 2008, the overall productivity improved by 12,5 index points. For example, in 1997, the relative level of real productivity in Estonia was 38,7 percent of the EU's. In 2008, today's level of real productivity in Estonia compared to the EU is 65,4 percent. Not surprisingly, there is an obvious empirical relationship between bargining power of the unions and slow productivity growth since economies with higher bargaining power of the unions tend to have lower productivity growth. Social democrats, the winners of the election, pledged to raise taxes on productive behavior. In that case, the growth of productivity would reduce to at least 2,5 percent in the medium run. In that case, Estonia's standard of living would catch-up Slovenia's standard of living in 13-14 years, assuming Estonia's 4,5 percent average productivity growth over the medium term. Unfamously, Slovenia is known for the highest rate of inflation in the EMU. Neither the introduction of euro, neither "fiscal impulse" are the flames of inflation which is (by the way), monetary phenomena True, lower interest rate in previous periods by the ECB may have boosted output activity and, at the same time, boosted the level of prices but, in retrospect, high rate of inflation is a consequence of rigid market structure that spills supply shocks into higher prices either because of oligopolistic market structure that imposes mark-ups on input prices, spilling it into consumer prices.

Looking to the Future

After the political turmoil, it is likely that left-leaning political parties will continue the statist course of economic policy with high tax burden in the share of the GDP, hostility towards financial markets (with enormously high tax rate on derivates) and foreign direct investment, postponing privatization with political management and meddling of inefficient state-owned companies. Tax rates will likely remain the highest in the region and Slovenia will, after Hungary and Croatia, remain the only country without flat-rated income tax. As in previous periods, there is little prospect for labor market deregulation that severely hampers productivity growth. In the long run, productivity is everything. After decades of market socialism, Slovenia's unique gradualist approach to economic reform, there is still much to be reformed immediately. Without tax cuts, market liberalization, reduced public spending, the economic growth, and consequently, the standard of living, would decline. Economic theory and practice teach us that there's no better welfare state than high economic growth, enabled by economic and individual freedom.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK


charlie said...

"Also, the entire tax code was gradually reduced from 5 tax brackets to 3 tax brackets with progressive income tax structure - 16 percent, 33 percent and 41 percent."

It's not 33 %, it's 27 %.

Rok Spruk said...

Thank you for the note. I corrected the misinformation in the text.

Best regards,

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