TAX WEDGE AND PRODUCTIVITY IN OECD COUNTRIES

The OECD Factblog highlighted a comparison of tax burden across the OECD countries. The main findings of the comparison is that overall tax burden, measured as a percentage of labor costs, is the highest in Western European countries. Belgium, Hungary, Germany and France are the countries with the highest overall tax burden while Ireland, Iceland, Australia and Korea have sustained low tax wedge. The data acquired by the OECD pose an intriguing question: is slow economic growth in European countries attributed to high tax burden of labor supply and, if so, has the gap between the U.S. and Europe grown further?

Let's decompose the data and underline the main findings. Tax wedge, measured as a percentage of taxes and transfers paid in the share of total labor costs, is a suficient measure of the overall level of taxation. In the analysis of the effect of taxation on labor supply, the economic theory distinguishes between substitution and income effect. The former means that tax rate on labor supply would reduce the number of working hours and shift the individuals to allocate more time into leisure. The income effect, on the other hand, states that the effect of tax on labor supply would be neutral and would, hence, not have an effect on the relative allocation of resources between working hours and leisure. In general, there are two largely opposing views in economic policy regarding the relationship between taxation and labor supply. Conservative and liberal economists tend to emphasize the role of incentives. Higher tax rate would raise the labor cost and the corresponding decline in wages would be offset by the re-allocation of resources into leisure sector of the economy. Left-wing economists mostly disagree with the abovementioned proposition. Instead, they emphasize the role of elasticity of labor supply. According to New Keynesian view, short-run tax elasticity of labor supply is low in absolute terms, meaning that the amount of working hours does not respond significantly to relative changes in tax rates. The Keynesian economists thus emphasize the significance of income effect while the conservative and liberal economists tend to emphasize the substitution effect. The distinctions and policy effects of these two theoretical propositions remains a controversial issue of economic policy debate.

The country distribution data is extensively underlined in the data (link). For example, one-earner married couple at 100 percent of earnings distribution is taxed at 20 percent of the overall labor cost in the United States, 22 percent in Australia, 18 percent in Switzerland and 13 percent in New Zealand. On the other tax wedge statistics for Western Europe is a completely different picture. In Sweden, one-earner married couple at 100 percent of earnings distribution will earn only 57 percent of net earnings, indicating a 43 percent effective tax rate on labor supply. In Belgium, the effective tax rate on labor supply is 42.6 percent. Is the difference in effective tax rates statistically significant feature of productivity variation across OECD countries. The OECD recently composed a breakdown in key productivity statistics in developed countries (link). To estimate the relationship between productivity and tax burden, I collected data on multifactor productivity dynamics from Groningen Growth and Development Center (link) and data on tax wedge across OECD countries (link). I estimated the noted relationship for 16 developed OECD countries. Multifactor productivity is a dependent variable while tax wedge is an explanatory variable.The estimates are displayed on the graph below.

Multifactor productivity in OECD relative to the U.S. and total tax burden (% of labor cost)

Source: GGDC, OECD Factblog

The horizontal line on the graphs marks the U.S. level of multifactor productivity. As the graph shows, the underlying relationship between multifactor productivity (MFP)and tax wedge is fitted with quadratic equation. Total tax wedge explains about 34.5 percent of the variation in multifactor productivity index across OECD countries. The trend exerts a decreasing MFP as the tax wedge rises and, after reaching a local minimum, a slight increase alongside the proporional rise in tax wedge. The relevant question is at which rate of tax wedge the MFP reaches the minimum. Setting the first-order derivate to zero (dy/dx=0) yields 0.0016x-0.0488=0. Rearranging the equation yields x=30.5. The first-order derivative implies that MFP reaches the minimum at 30.5 percent tax wedge. The estimate sample-based tax elasticity of productivity ((dy/dx)(x/y)) is 1.78. The elasticity indicates that 1 percentage point increase in tax wedge would reduce the multifactor productivity in a sample country by 1.78 percent, ceteris paribus. In other words, the estimated slope coefficient suggests that a 1 percentage point increase in tax wedge would widen the MFP gap between the average country and the US by additional 0.05 index points.

In economic terms, MFP would decrease as long as the countries in the sample would exert less than 30.5 percent tax wedge. In the horizon after the local minimum (30.5 percent), MFP would initially increase but at a smaller rate than before the function would reaches the minimum point. At 20 percent tax wedge (close to Japanese level), the expected decrease in MFP would be 0.0168 index point. At 40 percent tax wedge, the expected increase in MFP would be 0.0152 index point. Economically, the relationship between MFP and tax wedge should not be interpreted as a mixed effect of tax wedge on MFP. In countries, where tax wedge exceeds 30.5 percent (Austria, Denmark, Sweden, Belgium etc.) , the multifactor productivity is close to the U.S. level. The only country with higher MFP level than the United States is Luxembourg. In these countries, the average number of annual hours worked per worker is lower than in the U.S. Hence, hourly productivity output is higher. The following graph illustrates the relationship between annual hours worked (per worker) and MFP level.

Average annual hours worked per worker and multifactor productivity relative to the US

Source: OECD Statistics (2010)

As the graph illustrates, there is a negative relationship between average annual hours worked and MFP. The estimated regression coefficient suggests that an increase in annual hours worked by 100 hours would reduce MFP level (compared to the U.S) by 0.06 index points. As expected, the implied elasticity of productivity is negative. Taking the average values ov both variables, an increase in average annual hours worked (per worker) by 1 percent would reduce the MFP relative to the U.S level by 1.16 percent, ceteris paribus.

The conclusion is that there is a significant and negative impact of tax wedge on multifactor productivity. Taking the differences in annual hours worked into account, tax wedge alone explains almost 35 percent of the differential in multifactor productivity across the OECD. The findings suggest that there is a relatively strong substitution effect in labor supply. The finding is underlined by the fact that higher tax wedge would correspondingly reduce annual hours worked. However, the interpretation should be taken with a grain of warning. As previous empirical studies have shown, there is a widespread disparity in the distribution of working hours in formal and household sector of the economy. A sizeable proportion of working hours in household sector of the economy is not officially measured. Consequently, a blick of distortion of the real relationship between labor supply and tax wedge, in its broadest sense, is a major impediment to the measurement of labor supply dynamics. These estimates will, in a large part, determine the future research of the effect of taxation on labor productivity.

WELFARE STATE AND THE FUTURE OF EUROZONE

The $140 billion rescue package to Greece is a milestone in the European Monetary Union. A lively debate on recent macroeconomic imbalances in the weakest economies of the Euroarea - Greece, Italy, Spain and Portugal - in the Eurozone has reopened the old debate on whether the Eurozone is an optimum currency areas (here, here, here and here). The idea of optimum currency areas was first proposed by Nobel-winning economist Robert Mundell. In general, if several countries form a currency union, they should have at least four common macroeconomic features as essential framework of the currency union. In this article, I'll review the labor market criteria and fiscal adjustment criteria in the light of a recent imbalances in the Euroarea, and leave production diversification and export criteria for future discussion.

First, there should be a high degree of labor mobility between countries in the currency union. The basic idea behind the labor mobility criteria is that the lack of labor mobility triggers divergence of productivity growth rates and asymmetric adjustment of wages. If inter-country productivity divergence persists, there is an upward pressure on wages adjustment given the lack of exchange rate adjustment since the countries share a common monetary policy. The formation of the currency union in the United States was relatively straightforward given the fact that labor mobility between the states is very high. In Europe, the level of labor mobility is relatively low. The lack of labor mobility has a lot to do with labor market institutions in European countries. Workers from the European periphery can hardly move to Germany, Netherlands or Denmark as they do not speak the same language. The lack of inter-country mobility resulted in significant wage premiums and rise in rents since European labor markets share a pretty high degree of monopoly power since European workers can't switch easily between labor market structure. The resulting outcome of the lack of labor market competition was a significant "union capture" of the labor market, leading to rigid wage determination and high market switching costs.

Paul Krugman recently argued (link) that the major problem behind the European Monetary Union is the lack of common fiscal policy. To a very large extent, the absence of common fiscal policy seriously affects the future prospects of the European Monetary Union. Common fiscal policy could easily absorb asymmetric shocks withing the Euroarea. However, instituting the policy could not alter the trade-off between fiscal autonomy and asymmetric shock intensity. In other words, the main problem of the Euroarea right now is the free-riding of Eurozone's most problematic countries on a common monetary policy using disrectionary fiscal policy. Before the economic crisis, Spain had a budget deficit while, at the moment, the 2010 budget deficit forecast is more than 8 percent of the GDP. The estimate Greece's balooning public debt in 2009 ranges from 110 to 115 percent, depending on the consensus forecast. If the EMU countries unified a fiscal policy, the countries would not have an incentive to free-ride on discretionary fiscal policy and further increase the stock of public debt. The major impediment on the recovery and long-term economic outlook of Eurozone countries is largely dependent on how these countries will reform the pension systems in the light of a growing old-age dependence and a near fiscal insolvency of the pay-as-you-go (PAYG) pension schemes. It will be impossible to reverse the aging population and its persistent pressure on an increasing public debt. The integration of fiscal policy would require a sizeable harmonization of taxes given high costs of coordination and sufficient incentives for moral hazard. Without the reversion of long-term public debt pressure from aging, discretionary spending and entitlements, countries such as Greece, Spain and Portugal would leave the Eurozone.

THE EMPIRICS OF CORRUPTION, INSTITUTIONS AND ECONOMIC DEVELOPMENT

Urska Zagar posted two very interesting empirical articles (here and here) about the connections between corruption, economic freedom and economic welfare. The first two indicators are qualitative while the third one is rather easily measurable. In a sample of 50 advanced, developing and least developed countries, she found a positive and robust correlation between corruption perception and GDP per capita, meaning that higher GDP per capita, on average, reduces the scope of corruption. The relationship between corruption and economic development is in fact even more intriguing than empirical figures suggest.

The impact of corruption on economic growth is an important theoretical and empirical theme in the economic literature. In this theoretical and empirical post, I will briefly review the main literature on corruption and development and discuss the empirical studies.

I would firstly refer to the article by Rodrik, Subramanian and Trebbi (2002) where the authors discuss the primacy of institutions for economic development over the exogenous factors such as geography (link). There has been an extensive amount of literature on the role of geography in economic development. The empirical strategy is quite simple. Usually, the basic equation includes the list of explanatory variables such as distance from equator, the percentage of land used for agricultural production and so forth. For example, the basic equation might take the following form:

log(GDP)=b1+b2(Dist)+b3(Land)+b4(Dummy_SubAfrica)+e

where GDP stands for GDP per capita, Dist for distance from equator, Land for the percentage of fertilized land and Dummy_SubAfrica is a dummy variable, taking the value of 1 if a country is located in the Subsaharan Africa and 0 if otherwise. In addition, e represents stohastic error unexplained by the selected predictors.

However, the basic problem with geographic approach to explaining economic development is that the approach does not, by itself, distinguish between the endogenous features of economic development. In regressing GDP per capita on the distance from equator, the empirical estimates usually result in a modestly negative correlation between the two variables. However, the distance from the equator cannot itself explain the nature of economic development and its significance over time mainly because of its low predictive power in explaining the evolution of institutions and governance.

An interesting approach has been incorporated by Acemoglu, Johnson and Robinson (2001). They incorporate a historical and institutional perspective in the empirical framework of the explanation of economic development. The authors used mortality rates of colonial settlers to explain the institutional quality. They further argue that where settlers encountered few health hazards compared to European settlement, they established solid institutions, strong enforcement of property rights and a robust system of law. In other areas where health hazards frequently occured, colonizers focused on the extraction of natural resources and showed little or no interest in building high-quality institutions. Rodrik, Subramanian and Trebbi (2002) further estimated the impact of geographic variables, institutions and openness on macroeconomic variables.

The main findings in their study were the following. First, each degree distance towards equator, on average, reduces the income per capita by 0.94 percent. The geographical location by the equator is also negatively related to capital per worker (-1.68), human capital per worker (-0.25) and total factor productivity (-0.32). Second, the quality of institutions is a very good measure of the economic welfare. In their panel, the authors found that each additional improvement in the rule of law, on average, leads to 2.22 percent increase in income per capita. The result is statistically significant at 1 percent. The improvement of institutional quality is both positively related and statistically significant when capital per worker, human capital per worker and total factor productivity are regressed on the institutional quality.

Back in 1997, Peterson Institute published an extensive study, searching the causes of corruption (link). The author estimated that the highest cost of corruption in regressing a series of macroeconomic variables on corruption index is lower education expenditure and a decrease in private investment. The estimate of the total macroeconomic cost of corruption is a difficult and daunting empirical task.

The main causes of corruption are mostly endogenous and related to the institutional evolution ranging from legal origins, colonial historical variables to the public sector efficiency variables. In search of the grain of truth, it should be noted that capturing the stylized effect of corruption of economic growth and development requires an interactive empirical approach. In other words, it would be impossible to establish "cause-and-effect" connection between corruption and development indicators without extracting a large amount of historical data and regressing it on the key endogenous variables.

Clearly, the role of geographical characteristics should not be neglected. However, the primacy of institutions in explaining the contemporary patterns of economic development is rather undisputable. Daron Acemoglu recently wrote an in-depth article on the distribution and explanatory factors regarding world poverty (link) where it clearly stressed the lack of institutions of human capital in the evolution of world poverty. When discovering the true causes of corruption, there should nonetheless be a clear and distinct rationale underlined by the evolution of institutional quality over time as the most significant measure in explaining the evolution, causes and effects of corruption on economic development.

FEDERAL DEBT IN THE US (1940-2009)

Source: Office of Budget and Management (2010)

PRODUCTIVITY AND LABOR COSTS INDEX IN THE UNITED STATES

Bureau of Labor Statistics has recently published quarterly productivity and costs figures in the US nonfarm business sector (link).

EMU: RECOVERY OR DECLINE?

NY Times recently reported on the agreed financial rescue assitance to Grecce from EMU (€110 billion) and IMF ($145 billion). Alongside Ireland and Mediterranean countries, the economic recovery of EMU is hampered by a high mountain of public debt and unfavorable macroeconomic data on growth, employment and current account.

Public debt in the European Union in 2009

Source: Eurostat (2009)

The graph I attached, shows the level of public debt in EU countries in 2009. Solid horizontal blue line shows the 60 percent debt-to-GDP ratio required by Maastricht criteria for each EMU entrant.

The underlying data (link) on economic recovery in the US point out a strong and robust recovery. The data from Bureau of Economic Analysis show that the US economy grew by 3.2 percent in Q1:2010 continued from a remarkable 4.6 percent growth in Q4:2009. While private consumption expenditure growth increased by 2 percentage points from the previous quarter, private domestic investment rebounded by 14.8 percent in Q1:2010 after a remarkable 46.1 percent increase in Q4:2009. In addition, labor productivity in Q4:2009 increased by 6.9 percent - the largest quarterly increase since Q3:2003 (link) On the other side, recent revision (link) of quarterly growth rate in the EMU has shown that quarterly GDP in Q1:2010 increased by 0.0 percent, revised from 0.1 percent. Industrial confidence, an important measure of manufacturing outlook, further decline by 12.2 index points.

The macroeconomic outlook for the EMU is downsized by high public debt and negative budget deficit which led 10-year bond premium spread between EMU economies and Germany (link). The premium spread between Greece and Germany stood at 8.57 percentage points on April 28 while the spread between Ireland and Germany was at 2.54 percentage points.

High level of fiscal deficits restrains the economic recovery of the EMU countries. In 2009, Spain, Ireland and Greece faced the highest deficit-to-GDP ratio while Denmark's 2 percent deficit-to-GDP ratio was the lowest in the European Union. NY Times recently collected annual dataset on public debt and budget deficit (link) in which an overview of key public finance indicators is availible.

The prospects of economic recovery in the EMU are further downgraded by unfavorable growth forecast. One of the key questions during the ongoing debt crisis has been whether the EMU will sustain fiscal discrepancy within the EMU since asymmetric fiscal policy undermine the ability of the common monetary policy. Even though Greece's debt crisis is the core of the debate regarding future viability of the single currency, growth estimates for Spain and Italy in 2010/2011 will determine the mid-term macroeconomic stability of the eurozone. European Commission recently updated the quarterly economic growth estimates for eurozone countries (link). Depending on the absorption of financial market spillovers into investment and net exports, economic growth estimates for Italy and Spain are quite pessimistic. After an estimated 0.1 percent growth rate in Q2, Spain's economy is likely to contract in Q3 by -0.2 percent and experience a slight rebound in Q4:2010. Quarterly economic forecast for Italy is positive throughout the year although the economic growth rate is likely to be close to zero. However, Italy's economic growth rate is likely to keep the increasing pace towards the end of the year although current macroeconomic outlook deters consumption, investment and inventories' contribution to GDP growth mainly because of high unemployment rate and sluggish productivity growth.

Robust economic growth is essential to the cure of high public debt. Since EMU countries have adopted a single currency, policymakers cannot trigger exchange-rate adjustment through currency depreciation. The latter would spill into higher inflation and modestly reduce the volume of public debt. Due to high unemployment and slower recovery of inventories, inflation rate is unlikely to rebound to pre-crisis levels.

EMU's most problematic countries' recovery is unlikely to be robust given public debt and deficit constraint on quarterly growth outlook. Without a prudent fiscal tightening, lower government spending, there will be a bleak economic outlook for the future of EMU countries which could result in a decade-long period of low growth, high unemployment and Japan-styled deflationary persistence.

RENMIMBI APPRECIATION: AN UPDATE

Here (link) is an article by Barry Eichengreen discussed in the previous post.

RENMIMBI APPRECIATION

Barry Eichengreen wrote a thorough defence of China's exchange rate policy response to the global demands for letting the renmimbi appreciate and thus stimulate the reduction of US trade deficit.

US Treasury Department recently launched a series of initiatives which labelled China as a currency manipulator and a true source of America's widening trade deficit and loss of manufacturing jobs. I pretty much disagree with this particular assertion. China maintains a fixed exchange rate of renmimbi against the US dollar (6.83 RMB/1 USD). True, it is a very difficult empirical task to estimate the true exchange rate of the two currencies due to the fixed exchange rate. If Chinese policymakers let the renmimbi to float freely in global currency market, estimating the real exchange rate would be an easier task.

Low exchange rate against the USD stimulated a large surplus of foreign currency reserves and a large trade surplus from a significant export advantage againist foreign exporters. China's low GDP per capita is pretty much associated with country's sizeable share of investment in national income. Gradually, as Chinese GDP per capita will grow, the share of investment in GDP will correspondingly decline.

The macroeconomic cost of renmimbi appreciation is a daunting empirical task. Earlier estimates suggest that Chinese annual growth rate might be lower by 1-1.5 percentage point. Renmimbi appreciation would also induce Chinese growth pattern shift from investment and export-driven growth to consumption-based growth. It is only a sheer guess whether Chinese policymakers will embrace lower economic growth and a shift towards domestic consumption as the main engine of growth.

However, it would be foolish to mark China as currency manipulator and an ultimate source of US trade deficit and manufacturing loss. The latter can be solely explained by a change in productivity structure which offshored many of America's jobs and created even more jobs at home. The only feasible means of reducing US trade deficit is to cut a galloping fiscal deficit which, according to Congressional Budget Office (CBO), is likely to exceed 10 percent of the GDP in the medium term. A move to free-floating renmimbi exchange rate would yield substantial benefits for the world economy. However, China did a great jobs at ignoring Western political demands without any reliance on sound economic analysis

CHINA'S EXCHANGE RATE AND AMERICAN JOBS

Here's a brief Sunday reading list on the issue of China's exchange rate and US manufacturing jobs.

Simon J. Evenett and Joseph Francois on whether Chinese currency revaluation will create net jobs for the US economy (link).

William R. Cline's discussion of estimating the effect of renmimbi appreciation on American jobs (link).

Abdul Abiad, Daniel Leigh and Marco E. Terrones's analysis of cost of reducing large current account surplus (link).

Paul Krugman's discussion of Chinese exchange rate policy (link) (link)

EU vs. USA

I published a brief analysis (link) for the European Enterprise Institute, discussing a pattern of a growing income differential between the EU and America. The financial crisis diminished European growth rates and further widened the economic gap between the two continents.

Given a weak economic outlook for EU countries, the gap between European Union and the United States is likely to widen in the next decade although the US economy will be restrained by high tax burden and a growing federal debt. In 2010, I estimated the gap between the US and EU15 at 35-40 years, depending on EU's growth scenario.

INCOME INEQUALITY IN THE UNITED STATES

Gary Becker (link) and Richard Posner (link) opened an intense debate on the issue of a growing US income inequality since 1980s onwards.

VALUE-ADDED TAX FOR AMERICA?

Dan Mitchell wrote an interesting op-ed in NY Post (link) concerning the prospects of adopting a European-style value-added tax (VAT) in the United States.

Imposing a VAT would be detrimental to economic growth and productivity performance. If the U.S imposed the VAT, its spending levels would quickly approach the European spending levels. Indeed, the VAT is already used by OECD nations. In European Union, European Commission's Directive requires each country to harmonize value-added tax rate at the level of at least 15 percent. Federal spending in the U.S has already escalated. The consequence of $787 billion of stimulus measures is high public debt. Congressional Budget Office has forecasted the public debt to approach 70 percent of the GDP by 2012 and remain constant until 2020 (link). Rising costs of health care, entitlement spending and aging population have triggered government spending (link) and tax burden on the U.S firms and households. By 2020, health care spending is expected to reach 20 percent of the U.S GDP (link). Historical figures suggest a rather glimmering fiscal scenario for the United States in the next decade. In 1965, before the VAT spread across the European community, average tax burden of EU15 reached 27.7 percent of the GDP versus 24.7 percent in America. In 2006, the average tax burden for 15 developed European countries reached 39.8 percent. In United States, where VAT has not been introduced, average tax burden in 2006 remained close to the level of 1960s - at 28 percent of the GDP. The immediate consequence of VAT introduction in Europe was a surge in government spending. From 1965 to 2006, average government spending (as a share of the GDP) in the European Union increased by 17 percentage points while in America it increased by 7 percentage points. The total increase of spending growth in Europe and America is attributed to the widespread growth of the welfare state which includes entitlement spending and a growing cost of health care.

The economics of tax system is pretty straightforward. Alan Viard of the American Enterprise Institute (link) has outlined basic features of the VAT system. Contrary to the income tax system, VAT is a consumption tax. From the economic perspective, consumption tax is less distorting to economic behavior than the income tax. A pure VAT is tax at each stage of the supply chain. The taxation of individual income is a major distortion mostly because the source of direct taxation is labor supply. Introducing a tax on labor supply creates the so-called substitution effect where lower wage (w'=w(1-t)) is offset by a decrease in working hours and an increase in leisure hours either in pure leisure time or working more in household production or in the informal sector of the economy. Higher tax wedge in net wages has been the major factor behind fewer working hours in slow-growth European countries (Italy, France, Germany, Belgium etc.). The VAT is not as damaging as the income tax since the tax rate on individual consumption is applied when the income is already earned, so that income earning is not distorted. From a pure economic perspective, consumption taxation is more appropriate than income taxation mostly because the price elasticity of consumption goods is lower than price elasticity of labor supply. The consumption tax is based on the so-called Ramsey rule which states that the optimal tax rate is the inverse of the price elasticity of demand for a particular good ((t*=1/-dQ/dP*(P/Q)). It follows that on consumption goods with lower elasticity of demand, higher tax rate should be applied since the deadweight loss is smaller than in consumption goods with high price elasticity of demand. For example, price elasticity of demand is very low in goods such as gasoline since there's no close substitutes to gasoline. On the other hand, the elasticity of demand is pretty high in goods such as Big Mac or Coca Cola since there's a lot of substitutes for these goods (Subway snacks, Pepsi etc.) and a tax rate on Big Mac or Coca Cola can easily divert consumers to consume more Subway snacks, Pepsi or other goods.

While the introduction of a VAT is less income-distorting than a direct income tax, the imposition of both tax structures is a negative effect on economic growth, productivity and employment. Aside from the harmful taxation of income, the introduction of the VAT would further hamper individual consumption, raise consumer and producer prices and harm the manufacturing activity. One advantage of the VAT is a low cost and easy way of raising revenue. In economic theory, a uniform consumption tax is preferable to the income tax mostly due to fewer distortion in generating income which is the key feature of economic growth. A VAT also avoids imposing additional penalizing disincetives to labor supply and productivity.

Congressional Budget Office (link) has recently released Budget Outlook 2010, in which it laid out future perspectives of America's fiscal policy. Assuming an exerting pressure of tax burden in the coming years, the CBO has predicted the individual income taxes to grow from 6.4 percent in 2009 to 10.9 percent of the GDP by 2020. Imposing a VAT on top of the existing income tax would further reduce real disposable income and individual consumption. If a VAT were implemented on the federal or state level, there would be a significant and immediate increase in effective tax rates. The evolution of federal effective tax rates from 1970 to 2001 (link) shows a trend of decreasing effective tax rates and a growing after-tax income in all income quintiles.

The introduction of a VAT would dramatically change the US fiscal map. An article from OECD Observer (link) shows a comparative tax revenue distribution for the U.S, Europe and Japan. Back in 1999, the U.S was the only global economic giant with tax revenue from goods and service taxation of less than 30 percent of all tax revenues. The share remained steady until now. The non-existence of the VAT in America has contained the growth of overall tax burden. In 2004, total government revenues were 32 percent of the US GDP, far below the shares of high-tax countries. In Sweden, government revenue presented 59 percent of the GDP. While the U.S tax burden, measured as a share of government revenue in GDP, stayed below the level of France (50 percent), Germany (43 percent), Italy (45 percent), the introduction of a VAT may quickly turn America into a European-style country with high tax burden and benign economic growth. The international data (link) on total tax revenue in 2007 show that total tax revenue in the U.S presented 28.3 percent of the GDP. In 2007, taxes on goods and services presented about 4.7 percent of the US GDP; about three times less the level in Sweden (12.9 percent of the GDP) and four times less the level in Denmark (16.3 percent of the GDP). If a revenue from a VAT captured approximately 9.5 percent of the US GDP, America's tax revenue from a VAT would present about 14.2 percent of the GDP (9.5+4.7=14.2) comparable with high-tax countries such as Finland, Austria or Belgium and even more than in France.

Although the VAT is an easily applied method of taxing general consumption, imposing a VAT on the federal and state level would seriously harm America's future growth, investment, personal consumption, manufacturing activity and productivity. It would make America look like a typical slow-growth European welfare state for the first time.

GOOD NEWS ON GOOD FRIDAY

From BLS (link):

"Nonfarm payroll employment increased by 162,000 in March, and the unemploymentrate held at 9.7 percent, the U.S. Bureau of Labor Statistics reported today. Temporary help services and health care continued to add jobs over the month. Employment in federal government also rose, reflecting the hiring of temporaryworkers for Census 2010. Employment continued to decline in financial activities and in information. Among the major worker groups, the unemployment rates for adult men (10.0 percent), adult women (8.0 percent), teenagers (26.1 percent), whites (8.8 percent), blacks (16.5 percent), and Hispanics (12.6 percent) showed little or no change in March."

THE EUROPEAN BAY OF "PIIGS"

The Economist published a fascinating overview (link) of the macroeconomic indicators in Europe's most vulnerable economies in the current debt crisis (Portugal, Italy, Ireland, Greece, Spain).

ECONOMICS AND THE RETURN OF HISTORY?

In Friday's edition of NY Times, David Brooks wrote a very interesting column (link) discussing the state of economics. Although subtle and rigorous in its assertions I doubt that the field of economics needs a fundamental change in the philosophical origins of economic methodology. I agree with the author that economists often ignore the notion of moral philosophy and history in economic analysis but that doesn't mean that old textbooks on classical microeconomics need to be disposed. The author points out the role of economic forecasters who often appear on the TV, essentially trying to forecast economy's future path. Econometrics, which constitutes time-series forecasts on which most economic projections are based, is a real discipline to which numerous new scientific articles are devoted, published mostly in The Econometrics Journal and Econometrica. In his famous 1983 article (link) Let's take the con out of econometrics, Ed Leamer wrote how econometric modelling can be misused if a researchers ditch the true role and significance of assumptions. A prominent example is the study of death penalty on crime deterrence. As you can read in more detail in Leamer's article, one study found out that each capital punishment deters more than 9 murders while another one found out that each additional capital punishment causes more murders.

The contradicting evidence doesn't imply the falsification of the scientific method in economics. It merely reveals the hidden difference in how economists set assumptions regarding the behavior of individuals, firms and countries. David Brooks pointed out that economists failed to predict the recent financial crisis. However, many economists (myself included) pointed out the true dangers of an over-leveraged economy and monetary easing which led to subprime mortgage crisis and the consequential aftermath.

Many of us have had clear evidence, models and studies that showed how an over-leveraged financial sector can induce a significant economic downturn. However, many policymakers ignored the evidence of the behavior of the financial system which could be easily compared with chaos theory in mathematics. In my recent paper on Iceland's financial crisis I showed that the depository banks' overall leverage and indebtedness in the small country was growing exponentially, beyond the limit of capital adequacy.

As Paul Krugman recently noted, lessons from the Great Depression were not learned because people forgot it too quickly. Although mainstream economics, as every field within economic science, needs some major cures, I disagree with author's assertion that economics is not a real science but a moral philosophy. True, economics is not exact science because human behavior is not as experimental as particle analysis in physics but economics tries to resemble the scientific methodology through models, data, statistical inference and evidence. In fact, new interdisciplinary fields within economics are emerging such as behavioral economics, neuroeconomics and transport economics in which economic analysis is combined with other disciplines such as law, psychology, sociology and neuroscience.

The limits of mathematical recourse in economics were already discussed by economic thinkers such as John Maynard Keynes. And agreeably, mathematical reasoning is bounded by economic reasoning. However, from the real point of view, we need models to address human behavior mostly because, as F.A Hayek noted, it's too complex to capture its essence in a scientific entirety. If the neccesity of assumptions, models and evidence were not the case, hardly any lessons would be learned from the episodes of crises, booms, busts and periods of economic advancement in human history.

UK ECONOMY UNDER LABOUR PARTY

Daily Telepgraph collected a few interesting graphs (link) depicting the UK economic performance and discussing the economic legacy of the Labour Party.

LESSONS FROM CHILE

Hernan Buchi, former minister of finance in Chile, recently published a new book The Economic Transformation of Chile (link) where he outlined comprehensive economic reforms that boosted economic growth, lowered unemployment, reduced poverty and set the stage for more than two decades of robust growth and an economic turnaround which has been unprecendent in Latin America.

The books serves the reader with a menu of intriguing facts, curious statistics and precise analysis of how macroeconomic stability was achieved. Chile has been the leading nation in Latin America with the most stable and predictable inflation rate. Country's decent fiscal management and solid macroeconomic outlook were important cornerstones behind the invitation to the OECD.

According to Jose Pinera (link), Chile is expected to enter the club of developed nations in 2018, the first Latin American country ever. Chile pioneered the privatization of the pension system in early 1980s. Today, country's fully-funded pension system based on individual savings accounts is a model for the rest of the world (link) in overhauling unfunded pay-as-you-go social security systems.

TEXAS VS. CALIFORNIA

There's an interesting story from Washington Examiner (link) discussing the coming economic crisis in California (which has been notably called "The Greece of America") and the flourising economy in Texas which enjoyed a decade of robust growth, low taxes, favorable demographic outlook and superior public services. Not surprisingly, unions in free labor market in Texas did not allow public sector unions extracting $100 million from taxpayers for TV-adds in defence of the status quo for public employees:

"Californians have responded by leaving the state. From 2000 to 2009, the Census Bureau estimates, there has been a domestic outflow of 1,509,000 people from California -- almost as many as the number of immigrants coming in. Population growth has not been above the national average and, for the first time in history, it appears that California will gain no House seats or electoral votes from the reapportionment following the 2010 census... Texas is a different story. Texas has low taxes -- and no state income taxes -- and a much smaller government. Its legislature meets for only 90 days every two years, compared with California's year-round legislature. Its fiscal condition is sound. Public employee unions are weak or nonexistent."

ICELAND'S ECONOMIC AND FINANCIAL CRISIS

I recently presented my recent paper on Iceland's economic and financial crisis (link) in the European Parliament in Brussels (link). Three days ago, the publication of the paper has also been approved by the SSRN (link).

Let me briefly touch the evolution of Icelandic crisis. The roots of the Icelandic financial crisis go back to late 1980s, when the Icelandic economy recovered from subsequent periods of high, volatile and unpredictable inflation. In 1983, the annual inflation rate reached as high as 100 percent. Throughout the 1980s, the economic policymakers were gradually abandoning the Keynesian doctrine. Until the oil shocks plunged the country into rampant inflation and fragile economic growth, it was widely believed that a little higher inflation is the price of low unemployment.

The period from late 1980s to early 1990s had been an important milestone for Iceland's macroeconomic recovery alongside the change in the political tide. The central bank was granted independence in inflation targeting, the government pursued a wide array of structural and economic reforms to boost the economic growth. Corporate tax rate had been reduced from a near 50 percent bracket, labor and product markets were liberalized and the financial sector was in the beginning of the privatization. The beginning of the 20th century was an unusually favorable period for Iceland's macroeconomic stability. Aside from one of the world's best institutions and governance, Iceland is perhaps the only developed country with favorable long-term demographics. The share of the population above the age thresold of 65 is only 11 percent. For instance, in Italy more than 20 percent of the population is in the age thresold of 65 and above. Iceland's favorable demographic outlook and a bold move towards defined-contribution pension system make the country the only developed nation with stable and fiscally solvent social security transition in the long-run. (total assets of pension funds as a share of GDP stood at 114 percent of the GDP in 2008 - more than any other OECD nation).

In 2001/2002, Iceland fell into a short-lived recession, mostly as a result of external imbalances and current-account adjustment to the global economic slowdown. In spite of the favorable macroeconomic outlook, Iceland's central bank failed in terms of the inflation targeting. From 1980 onwards, Iceland has had the most volatile inflation rate in the OECD, surpassing countries with unstable inflation such as Greece. Between 1980 and 2009, the average standard deviation of inflation was 20.45 percentage points, almost 20 times the deviation of inflation in countries with the least volatile inflation (Austria, Germany, Netherlands). Behind the unpredictable inflation rate was an unprecendent development of banking and financial industry. Iceland maintained high interest rate to contain inflationary pressures which were the main threat to macroeconomic stability since 1980s. Consequently, there was a large interest rate differential between Iceland and the rest of the world.

In a small and open economy such as Iceland high interest rate differential triggered "carry trading" against uncovered interst parity. Investors thus borrowed in Icelandic currency and invested in Icelandic stock and bonds in search of high short-term yields and then, after a certain period of time, swapped it into safer currencies. In the mean time, Icelandic currency (Krona) strongly appreciated and created an artificial wealth illusion which stimulated imports and further boosted economic growth towards an incredible 7 percent in 2007. The central bank raised the key interest rate further to contain potential inflationary pressure. Consequently, massive capital inflows strengthened krona's appreciation.

At the same time, the banking industry expanded abroad and enjoyed significant return on equity as a result of high interest margins on short-term loans in Krona-denominated loans. Icelandic banks were recognized as well-managed and, at the same time, enjoyed favorable ratings from Fitch, S&P and Moody. Three largest banks (Kaupthing, Glintir and Landsbanki) grew for more than 10 times the country's GDP. These banks easily expanded abroad as world interest rates converged towards zero. In such circumstances, banks offered loans in foreign currency and enjoyed strong interest margins from short-term loans in domestic currency. Icelandic households avoided loans in Icelandic currency given high interest rate but had significant foreign currency loan portfolio offered at very low rates. In a few years, loans in foreign currency exceeded domestic money supply by several times.

From 2004 onwards, Iceland's banking industry emerged as one of the most over-leveraged in the world. High leverage could be sustained as long as the global interbank marked was stable. When the subprime mortgage crisis spread across the U.S, there were early signs that Iceland will likely experience a significant contraction and current account deficit. For example, Danske Bank from Denmark warned in 2006 how disastrous could be the Icelandic crisis:

“On most measures, the small Icelandic economy is one of the most overheated in the OECD. Unemployment stands at 1 percent, wage growth is above 7 percent, and inflation is running above 4 percent despite a strong ISK. The current account deficit is closing in on 20 percent of the GDP. The Icelandic central bank has been hiking rates substantially in order to cool the economy and rates are now above 10 percent. Based on the macro data alone, we think that the economy is heading for a recession in 2006-07. GDP could probably dip 5-10 percent in the next two years and inflation is likely to spike above 10 percent as the ISK depreciates markedly. However, on top of the macro boom, there has been a stunning expansion of debt, leverage and risk-taking that is almost without precedence anywhere in the world. External debt is now at 300 percent of the GDP while short-term external debt is just short of 55 percent of the GDP. This is 133 percent of Icelandic export revenues.”

The global interbank market froze after the failure of Lehman Brothers when the crisis spread globally. At that time, CDS rates on Icelandic banks rose as investors demanded higher premia given the significant magnitude of financial risk. Bond spreads literally exploded. The three largest banks filed for bankruptcy. When the banks failed, gross external liabilites rose to more than 900 percent of country's GDP. Given spare fiscal and monetary capacity, the central bank failed to act as a lender of the last resort and the bailout such as Bear Stearns seemed implausible. The country fell into the deepest and most significant crisis ever experienced by a small country in a peace-time history. The recession, which lasted for more than year, was marred by turbulent inflation rate, stunning negative output gap and high unemployment rate.

The prospects for the Icelandic recovery were initially bleak due to unemployment surge, current account deficit and high public debt. In 2010, the recovery prospects seem more favorable with economic growth rate returning to 4 percent level by 2014. There's also been a lot of debate about Iceland's potential EMU membership - mostly in the light of Icesave deposit repayment to Dutch and British taxpayers. As I thoroughly discussed in the paper, Iceland is not an optimum currency area mostly because adjustment to common monetary policy would require a substantial exchange rate alignment which would inevitably result in inflationary wage pressure and seriously deteriorate country's macroeconomic stability in the long run.

CHINA'S EXCHANGE RATE POLICY

Paul Krugman (link) and Greg Mankiw (link) analyze the costs and benefits of China's exchange rate policy.