Posts Tagged ‘regulation’

will higher tax rates bring more money?

December 16, 2009

This week the Greek prime minister produced an array of measures to cut the deficit over the next year or so. Most of them amount to either direct tax increases (a progressive tax rate with a maximum up to 50%, a tax or millage levy on large properties, the re-introduction of inheritance tax, 90% tax on bank bonuses) or indirect taxation (freeze of civil servant salaries beyond a EUR2,000 threshold, no bonuses in government run organisations). The question is of course whether or not these measures will bring more money in the depleted state coffers.

What is the evidence? Kurt Hauser in 1993 observed that “no matter what the tax rate has been, the post-war tax revenues in America have been stable and around 19.5%”. This observation became known as “Hauser’s law”. Taxation is not ‘static’, as economic agents will have an increasing incentive to use accounting techniques to shift or hide their tax exposure. In addition, increasing tax rates will have an adverse impact on the GDP and thus increasing taxes will reduce the actual Euro amount that comes in the government coffers.

This article in the WSJ revived Hauser’s law in 2008, and the 15 years of new data also confirm its validity.

Tax receipts and rate

Greek tax receipts (blue) and the tax rate (red). Dotted line for projected values. Source: Eurostat

But what is the evidence for Greece? Unfortunately the statistical data are scarce and not overly reliable, but I managed to dig some information from the EuroStat website from 1995 onwards. The effective tax rate for a family of two full-time working individuals with two children has risen from 18% in 1995 to about 24% in 2000, 25% in 2004 and 27% today. On the other hand the tax receipts as a percentage of GDP have remained without a clear trend at about… errrr 20%.

For that allow me to be sceptical on the effectiveness of these measures.

PS: The data I managed to dig are as follows (P denotes a projection, otherwise known as a wish :–) (a) tax rate 96-08: 17.9, 18.2, 18.5, 17.8, 23.9, 23.7, 24.6, 23.2, 25.5, 26.1, 27.8, 27.6, 27.2; (b) tax receipts 95-04 projected to 07: 19.0, 19.1, 20.0, 21.6, 22.6, 23.5, 22.1, 21.7, 20.0, 19.8, P20.3, P20.3, P20.3


The case for fragile regulation

April 7, 2009

Arnold Kling has a very interesting piece on regulation. Crises are endogenous, as economic agents and market participants learn how to game the system. He argues, that we are facing two alternatives: a system that does not break easily, but when it does it is costly and difficult to fix, or a system that breaks more frequently but is easier and cheaper to repair.

Kling argues that measures taken following crises are pivotal in creating the next one. He draws his examples from the mortgage markets from the Great Depression of the 30s, to the Savings and Loans crisis of the 80s, to today’s securitization dead end.

After the Depression it was acknowledged that mortgages with balloon payments are too sensitive to credit shortages. Balloon mortgages have a short term, say 5 years, but the monthly payments are similar to a long term mortgage, say 30 years. This means that in the end of the 5 year period there will be a substantial part of the capital still in place (the balloon), which has to be refinanced. If there is a credit crisis, refinancing might not be an option, leading to foreclosures. To this end long term fixed rate mortgages and adjustable rate mortgages (where refinancing is essentially mandatory) were subsequently encouraged. Such mortgages were given by Savings and Loan associations in the US, or Building Societies in the UK. Fannie Mae was established to promote and guarantee mortgages to families with lower income.

But this shifts the maturity mismatch from the mortgagor (borrower) to the mortgagee (lender). They would borrow short (from their depositors) and lend long in the form of mortgages. In the high inflation and interest rate period of the 70s and 80s, they would receive low cashflows from past mortgages, while at the same time they had to pay higher interest rates to their depositors in order to cling on their deposits. This eventually led to the crisis, where it was made clear that such maturity mismatches were also unsustainable. What emerged from the crisis was securitization, as a means of offloading the long component of their assets. In an ideal world, institutions that had long term liabilities (like insurance companies) would be the buyers of these long term assets.

Unfortunately, it didn’t work as intended with the current crisis being a direct result. Rather than insurance companies, it was investment banks and hedge funds that were left with mortgage backed assets. Also, the originating mortgage providers lost the incentive to monitor the quality of the mortgages they were granting.

The bottom line is that regulation, albeit well meaning, cannot be all encompassing and accommodating. Market participants will eventually work their way around, and there will be unforeseen consequences. It would be better then to have a fast moving framework that keeps the spirit rather than putting rigid constraints.

This is al good in paper of course, but how would such a flexible regulatory framework look like? What capacities should regulatory bodies have to make sure that the system does not descend into chaos? In a world run by politicians that want to cover their bases, the easy option is to talk big and construct a rigid international financial system. Which will probably take us back to the 1930s.