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Articles for the ‘Economics 8e: Ch 10’ Category

Rich and poor in the UK

The ONS has just released its annual publication, The Effects of Taxes and Benefits on Household Income. The report gives data for the financial year 2012/13 and historical data from 1977 to 2012/13.

The publication looks at the distribution of income both before and after taxes and benefits. It divides the population into five and ten equal-sized groups by household income (quintiles and deciles) and shows the distribution of income between these groups. It also looks at distribution within specific categories of the population, such as non-retired and retired households and different types of household composition.

The data show that the richest fifth of households had an average pre-tax-and-benefit income of £81,284 in 2012/13, 14.7 times greater than average of £5536 for the poorest fifth. The richest tenth had an average pre-tax-and-benefit income of £104,940, 27.1 times greater than the average of £3875 for the poorest tenth.

After the receipt of cash benefits, these gaps narrow to 6.6 and 11.0 times respectively. When the effect of direct taxes are included (giving ‘disposable income’), the gaps narrow further to 5.6 and 9.3 times respectively. However, when indirect taxes are also included, the gaps widen again to 6.9 and 13.6 times.

This shows that although direct taxes are progressive between bottom and top quintiles and deciles, indirect taxes are so regressive that the overall effect of taxes is regressive. In fact, the richest fifth paid 35.1% of their income in tax, whereas the poorest fifth paid 37.4%.

Taking the period from 1977 to 2012/13, inequality of disposable income (i.e. income after direct taxes and cash benefits) increased from 1977 to 1988, especially during the second two Thatcher governments (1983 to 1990) (see chart opposite). But then in the first part of the 1990s inequality fell, only to rise again in the late 1990s and early 2000s. However, with the Labour government giving greater cash benefits for the poor, inequality reduced once more, only to widen again in the boom running up to the banking crisis of 2007/8. But then, with recession taking hold, the incomes of many top earners fell and automatic stabilisers helped protect the incomes of the poor. Inequality consequently fell. But with the capping of benefit increases and a rise in incomes of many top earners as the economy recovers, so inequality is beginning to rise once more – in 2012/13, the Gini coefficient rose to 0.332 from 0.323 the previous year.

As far as income after cash benefits and both direct and indirect taxes is concerned, the average income of the richest quintile relative to that of the poorest quintile rose from 7.2 in 2002/3 to 7.6 in 2007/8 and then fell to 6.9 in 2012/13.

Other headlines in the report include:

Since the start of the economic downturn in 2007/08, the average disposable income has decreased for the richest fifth of households but increased for the poorest fifth.

Cash benefits made up over half (56.4%) of the gross income of the poorest fifth of households, compared with 3.2% of the richest fifth, in 2012/13.

The average disposable income in 2012/13 was unchanged from 2011/12, but it remains lower than at the start of the economic downturn, with equivalised disposable income falling by £1200 since 2007/08 in real terms. The fall in income has been largest for the richest fifth of households (5.2%). In contrast, after accounting for inflation and household composition, the average income for the poorest fifth has grown over this period (3.5%).

This is clearly a mixed picture in terms of whether the UK is becoming more or less equal. Politicians will, no doubt, ‘cherry pick’ the data that suit their political position. In general, the government will present a good news story and the opposition a bad news one. As economists, it is hoped that you can take a dispassionate look at the data and attempt to relate the figures to policies and events.

Report
The Effects of Taxes and Benefits on Household Income, 2012/13 ONS (26/6/14)

Data
Reference tables in The Effects of Taxes and Benefits on Household Income, 2012/13 ONS (26/6/14)
The Effects of Taxes and Benefits on Household Income, Historical Data, 1977-2012/13 ONS (26/6/14)
Rates of Income Tax: 1990-91 to 2014-15 HMRC

Articles
Inequality is on the up again – Osborne’s boast is over New Statesman, George Eaton (26/6/14)
Disposable incomes rise for richest fifth households only Money.com, Lucinda Beeman (26/6/14)
Half of families receive more from the state than they pay in taxes but income equality widens as rich get richer Mail Online, Matt Chorley (26/6/14)
Rich getting richer as everyone else is getting poorer, Government’s own figures reveal Mirror, Mark Ellis (26/6/14)
The Richest Households Got Richer Last Year, While Everyone Else Got Poorer The Economic Voice (27/6/14)

Questions

  1. Define the following terms: original income, gross income, disposable income, post-tax income, final income.
  2. How does the receipt of benefits in kind vary across the quintile groups? Explain.
  3. What are meant by the Lorenz curve and the Gini coefficient and how is the Gini coefficient measured? Is it a good way of measuring inequality?
  4. Paint a picture of how income distribution has changed over the past 35 years.
  5. Can changes in tax be a means of helping the poorest in society?
  6. What types of income tax cuts are progressive and what are regressive?
  7. Why are taxes in the UK regressive?
  8. Why has the fall in income been largest for the richest fifth of households since 2007/8? Does this mean that, as the economy recovers, the richest fifth of households are likely to experience the fastest increase in disposable incomes?
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The world’s highest minimum wage

We have had a minimum wage in the UK for well over a decade and one its key purposes was to boost the pay of the lowest paid workers and in doing so reduce the inequality gap. Rising inequality has been a concern for many countries across the world and not even the nations with the most comprehensive welfare states have been immune.

Switzerland, known for its banking sector, has been very democratic in its approach to pay, holding three referenda in recent years to give the Swiss public the chance to decide on pay. Imposing restrictions on the bonuses available to the bosses of the largest companies was backed in the first referendum, but in this latest vote, the world’s highest minimum wage has been rejected. The proposed wage is the equivalent of £15 per hour and it is the hourly wage which proponents argue is the wage needed to ensure workers can afford to ‘live a decent life’. However, prices in Switzerland are considerably higher than those in the UK and this wage translates to around £8.33 per hour in purchasing power parity terms, according to the OECD. In the UK, much debate has surrounded the question of a living wage and the impact that a significant increase in the NMW would have on firms. The concern in Switzerland has been of a similar nature.

With a higher wage, costs of production will inevitably rise and this is likely to lead to firms taking on fewer workers and perhaps moving towards a different mix of factors of production. With less workers being employed, unemployment would be likely to increase and it may be that the higher costs of production are passed onto consumers in the form of a higher price. One problem is that as prices rise, the real wage falls. Therefore, while advocates of this high minimum wage suggest that it would help to reduce the gap between rich and poor, the critics suggest that it may lead to higher unemployment and would actually harm the lowest paid workers. It appears that the Swiss population agreed with the critics, when 76% voted against the proposal. Cristina Gaggini, who is the Director of the Geneva Office of the Swiss Business Association said:

I think [it would have been] an own goal, for workers as well as for small companies in Switzerland … Studies show that a minimum wage can lead to much more unemployment and poverty than it helps people … And for very small companies it would be very problematic to afford such a high salary.

The proposal was made by Swiss Unions, given the high cost of living in Switzerland’s suggest cities. It was rejected by the Swiss Business Federation and government and this was then echoed by the overwhelming majority in the referendum. Switzerland has been found to be the most expensive place to live in the world and the wages paid are insufficient to provide a decent life, with many claiming benefits to support their earnings. The debate over the minimum wage and the living wage will continue in countries across the world, but for now the Swiss people have had their say. The following articles consider this issue.

Switzerland rejects world’s highest minimum wage BBC News (18/5/14)
Swiss voters reject plan to establish world’s highest minimum wage The Guardian, Julia Kollewe (18/5/14)
Swiss voters reject setting world’s highest minimum wage Wall Street Journal, Neil Maclucas (18/5/14)
Swiss voters reject world’s highest minimum wage, block fighter jets Reuters, Caroline Copley (18/5/14)
Switzerland votes on world’s highest minimum wage at £15 per hour Independent, Loulla-Mae Eleftheriou-Smith (18/5/14)
Swiss reject highest minimum wage in world Financial Times, James Shotter (18/5/14)
Swiss reject world’s highest minimum wage, jet purchase Bloomberg, Catherine Bosley (18/5/14)

Questions

  1. Using a demand and supply diagram, illustrate the impact of a national minimum wage being imposed.
  2. Using the diagram above, explain the impact on unemployment and evaluate the factors that determine the amount of unemployment created.
  3. Given what you know about the proposed Swiss minimum wage, how much of an impact on unemployment do you think there would be?
  4. Draw a diagram to show the effect on a firm’s costs of production of the national minimum wage. Explain how such costs may affect the prices consumers pay for goods and services.
  5. How is it possible that a higher minimum wage could actually lead to more inequality within a country?
  6. Is there a chance that a minimum wage could lead to inflation? What type would it be?
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BBC Radio 4: The future is not what it used to be

On my commute to work on the 6th May, I happened to listen to a programme on BBC radio 4, which provided some fascinating discussion on a variety of economic issues. Technological change is constant and unstoppable and the consequences of it are likely to be both good and bad.

In this programme some top economists, including Joseph Stiglitz offer their analysis of the impact of technology and how the future might look, by considering a range of factors, such as youth unemployment, the productivity of labour, education, pensions and inequality. The benefits of new technology can be seen as endless, but the impact on inequality and how the benefits of technology are being distributed is a concern for many people. The best introduction to the programme and its content is simply to reproduce the description provided by BBC radio 4.

The baby boom generation came of age when it was accepted knowledge that innovation and productivity would always lead to higher standards of living. The generations which followed assumed this truth would continue into the future indefinitely. With the crash of 2008 the upward mobility the middle classes assumed was their right evaporated, and it is unlikely to return.

Martin Wolf, chief economics commentator of the Financial Times, asks how the work force of the future will be changed by the advancements of technologies. How should governments respond to a jobs market which is hollowing out opportunities for traditional educated professions and how will rewards for innovation and income for labour be distributed without creating a society plagued by endemic inequality?

We will speak with optimists and pessimists on both sides of the argument to find out how the repercussions of these changes will affect the way we all live now and well into the future.

It is well worth listening to and provides some interesting insights as to what the future might look like, as the inevitable technological change continues. The link for the programme is below.

The future is not what it used to be BBC Radio 4 (6/5/14)

Questions

  1. What are the expected costs and benefits of technological change?
  2. Which factors are discussed as being the main obstacles to upwards mobility? Why have these become more prevalent in recent decades?
  3. Using a diagram, explain how technology can improve economic growth. To what extent is the multiplier effect important here?
  4. How is technology expected to affect the labour market? Use a diagram to help your explanation and make sure you consider both sides of the argument.
  5. What is meant by the idea that the benefits of new technology are likely to be felt in the long run?
  6. How important is education in creating equal opportunities?
  7. What is meant by secular stagnation? Is it seen as being a problem?
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Life expectancy, how much information is too much information?

Life expectancy is increasing across the world and the latest set of figures from the Office for National Statistics show that in the UK it has passed 79 for boys born in 2010–12, and 82 for girls born then. In fact the prediction is that over a third of babies born in 2013 will live to more than 100. The data throws up some interesting questions. How well prepared are we for lives that last this long? And how evenly distributed is this increase in life expectancy? Pensions’ minister, Steve Webb, has called for better information on life expectancy to be shared. How would this impact on our decision making?

It seems reasonable to think that increasing life expectancy must be good news. And of course, for individuals it can be. In 1951 the average man retiring at 65, in England and Wales, could expect to live and draw a pension for another 12.1 years. By 2014 this had risen to 22 years.

But while we can look forward to longer life, for the government, it presents some challenges The first is that we just don’t save enough for our old age. This seems to be partly because we find it hard to make decisions that will have an impact so far in the future. There are a number of measures that have been put in place to encourage us to save more, including auto-enrolment into company pension schemes. This is being rolled out across businesses over the next three years. In the 2014 Budget, the Chancellor announced that people reaching retirement age will be able to draw all their pension as a cash lump sum, rather than having to take it as a regular income.

Another concern for government is the variations that we find in life expectancy across the UK. The 2014 ONS data identified that life expectancy for men born in Glasgow in 2012 is 72.6, in East Dorset it is 82.9. 25% of those in Glasgow are not expected to live to 65. The gap in years of good health is even greater. This presents governments with a long-term problem. How do they achieve greater equality in this instance? Do they focus resources on the areas that need it most? Do they legislate to address behaviour? Or do they rely on the provision of good advice – on diet, exercise and other factors?

Information has a role to play in both areas identified above. In April 2014, Steve Webb, suggested that in order to make good decisions at the point of retirement, people need to understand more about what lies ahead. He said:

People tend to underestimate how long they’re likely to live, so we’re talking about averages, something very broad-brush. Based on your gender, based on your age, perhaps asking one or two basic questions, like whether you’ve smoked or not, you can tell somebody that they might, on average, live for another 20 years or so.

This suggestion has led to some concerns being expressed at what appears to be an over-simplistic approach. Estimates can only be based on a mix of averages modified by individual information. Would the projections be shared with pension providers? What would you do if you exceeded your forecast life expectancy – by a long way – and had spent all your money? Could you sue someone?

Will your pension pot last as long as you will? The Telegraph, Dan Hyde and Richard Dyson (23/4/2014)
Scientists invent death test that will tell us how long we have to live Metro (11/8/13)
Games host Glasgow has worst life expectancy in the UK The Guardian, Caroline Davies (16/4/2014)
Pensioners could get life expectancy guidance BBC News Politics (17/4/14)
ONS reveals gaps in life expectancy across the UK FT Adviser Pensions, Kevin White (23/4/14)
Health care aid for developing countries boosts life expectancy Health Canal, Ruth Ann Richter (22/4/14)
A third of babies born this year will live to 100 This is Money.co.uk, Adam Uren (11/12/13)

Questions

  1. Thinking about the UK, what are the factors that might explain variations in life expectancy across different regions? How might the government address these differences? Why would they want to do so?
  2. Do the same factors explain variations between countries? Who can address these differences? Who would want to do so?
  3. If you could have a reasonable prediction of your life expectancy at 65, would you want it? How would your behaviour change if you were predicted a longer than average life expectancy? How would it change if you were predicted a shorter than average life expectancy?
  4. If you could have an accurate prediction of your life expectancy at 18, how would your answers differ? If this were possible, would it present any problems?
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Pensioner hazard

In his Budget on March 19, the Chancellor of the Exchequer, George Osborne, announced fundamental changes to the way people access their pensions. Previously, many people with pension savings were forced to buy an annuity. These pay a set amount of income per month from retirement for the remainder of a person’s life.

But, with annuity rates (along with other interest rates) being at historically low levels, many pensioners have struggled to make ends meet. Even those whose pension pots did not require them to buy an annuity were limited in the amount they could withdraw each year unless they had other guaranteed income of over £20,000.

Now pensioners will no longer be required to buy an annuity and they will have much greater flexibility in accessing their pensions. As the Treasury website states:

This means that people can choose how they access their defined contribution pension savings; for example they could take all their pension savings as a lump sum, draw them down over time, or buy an annuity.

While many have greeted the news as a liberation of the pensions market, there is also the worry that this has created a moral hazard. When people retire, will they be tempted to blow their savings on foreign travel, a new car or other luxuries? And then, when their pension pot has dwindled and their health is failing, will they then be forced to rely on the state to fund their care?

But even if pensioners resist the urge to go on an immediate spending spree, there are still large risks in giving people the freedom to spend their pension savings as they choose. As the Scotsman article below states:

The risks are all too obvious. Behaviour will change. People who no longer have to buy an annuity will not do so but will then be left with a pile of cash. What to do with it? Spend it? Invest it? There are many new risky choices. But the biggest of all can be summed up in one fact: when we retire our life expectancy continues to grow. For every day we live after 65 it increases by six and a half hours. That’s right – an extra two-and-a-half years every decade.

The glory of an annuity is it pays you an income for every year you live – no matter how long. The problem with cash is that it runs out. Already the respected Institute for Fiscal Studies (IFS) has said that the reform ‘depends on highly uncertain behavioural assumptions about when people take the money’. And that ‘there is a market failure here. There will be losers from this policy’.

We do not have perfect knowledge about how long we will live or even how long we can be expected to live given our circumstances. Many people are likely to suffer from a form of myopia that makes them blind to the future: “We’re likely to be dead before the money has run out”; or “Let’s enjoy ourselves now while we still can”; or “We’ll worry about the future when it comes”.

The point is that there are various market failings in the market for pensions and savings. Will the decisions of the Chancellor have made them better or worse?

Articles
Pension shakeup in budget leaves £14bn annuities industry reeling The Guardian, Patrick Collinson (20/3/14)
Chancellor vows to scrap compulsory annuities in pensions overhaul The Guardian, Patrick Collinson and Harriet Meyer (19/3/14)
Labour backs principle of George Osborne’s pension shakeup The Guardian, Rowena Mason (23/3/14)
Osborne’s pensions overhaul may mean there is little left for future rainy days The Guardian, Phillip Inman (24/3/14)
Let’s celebrate the Chancellor’s bravery on pensions – now perhaps the Government can tackle other mighty vested interests Independent on Sunday, Mary Dejevsky (23/3/14)
A vote-buying Budget The Scotsman, John McTernan (21/3/14)
L&G warns on mis-selling risks of pension changes The Telegraph, Alistair Osborne (26/3/14)
Budget 2014: Pension firms stabilise after £5 billion sell off Interactive Investor, Ceri Jones (20/3/14)

Budget publications
Budget 2014: pensions and saving policies Institute for Fiscal Studies, Carl Emmerson (20/3/14)
Budget 2014: documents HM Treasury (March 2014)
Freedom and choice in pensions HM Treasury (March 2014)

Questions

  1. What market failures are there in the market for pensions?
  2. To what extent will the new measures help to tackle the existing market failures in the pension industry?
  3. Explain the concept of moral hazard. To what extent will the new pension arrangements create a moral hazard?
  4. Who will be the losers from the new arrangements?
  5. Assume that you have a choice of how much to pay into a pension scheme. What is likely to determine how much you will choose to pay?
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Private versus public

Many people are attracted to work in the private sector, with expectations of greater opportunities for promotion, more variation in work and higher salaries. However, according to the Office for National Statistics, it may be that the oft-talked-of pay differential is actually in the opposite direction. Data from the ONS suggests that public sector workers are paid 14.5% more on average than those working in the private sector.

As is the case with the price of a good, the price of labour (that is, the wage rate) is determined by the forces of demand and supply. Many factors influence the wages that individuals are paid and traditional theory leads us to expect higher wages in sectors where there are many firms competing for labour. With the government acting as a monopsony employer, it has the power to force down wages below what we would expect to see in a perfectly competitive labour market. However, the ONS data suggests the opposite. What factors can explain this wage differential?

Jobs in the public sector, on average, require a higher degree of skills. There tend to be entry qualifications, such as possessing a university degree. While this is the case for many private-sector jobs as well, on average it is a greater requirement in the public sector. The skills required therefore help to push up the wages that public-sector workers can demand. Another explanation could be the size of public-sector employers, which allows them to offer higher wages. When the skills, location, job specifications etc. were taken into account, the 14.5% average hourly earnings differential declined to between just 2.2% and 3.1%, still in favour of public-sector workers. It then reversed to give private-sector workers the pay edge, once the size of the employer was taken out.

Further analysis of the data also showed that, while it may pay to be in the public sector when you’re starting out on your career, it pays to be in the private sector as you move up the career ladder. Workers in the bottom 5% of earners will do better in the public sector, while those in the top 5% of earners benefit from private-sector employment. The ONS said:

Looking at the top 5%, in the public sector earnings are greater than £31.49 per hour, while in the private sector, the top 5% earn more than £33.63 per hour… The top 1% of earners in the private sector, at more than £60.21 per hour, earns considerably more than the top 1% of earners in the public sector, at more than £49.65 per hour.

The data from the ONS thus suggest a reversal in the trend of average public-sector pay being higher than private sector pay, once all the relevant factors are taken into account.

This will naturally add to debates about living standards, which are likely to take on a stronger political slant as the next election approaches. It is obviously partly down to the public-sector pay freeze that we saw in 2010 and also to a reversal, at least in part, of the previous trend from 2008, where public-sector pay had been growing faster than private-sector pay. However, depending on the paper you read or the person you listen to, they will offer very different views as to who gets paid more. All you need to do in this case is look at the titles of the newspaper articles written by the Independent and The Telegraph! Whatever the explanation, these new data provide a wealth of information about relative prospects for pay for everyone.

Data
Public and Private Sector Earnings Office for National Statistics (March 2014)
Annual Survey of Hours and Earnings, 2013 Provisional Results Office for National Statistics (December 2013)

Articles
Austerity bites as private sector pay rises above the public sector for the first time since 2010 Independent, Ben Chu (10/3/14)
Public sector workers still better paid despite the cuts The Telegraph, John Bingham (10/3/14)
Public sector hourly pay outstrips private sector pay BBC News (10/3/14)
Public sector workers are biggest losers in UK’s post-recession earnings squeeze The Guardian, Larry Elliott (11/3/14)
New figures go against right-wing claims that public sector workers are grossly overpaid Independent, Ben Chu (10/3/14)
Public sector pay sees biggest shrink on 2010, figures suggest LocalGov, Thomas Bridge (11/3/14)
Public sector staff £2.12 an hour better off The Scotsman, David Maddox (11/3/14)

Questions

  1. Illustrate the way in which wages are determined in a perfectly competitive labour market.
  2. Why does monopsony power tend to push wages down?
  3. Why does working for a large company suggest that you will earn a higher wage on average?
  4. Using the concept of marginal revenue product of labour, explain the way in which higher skills help to push up wages.
  5. How significant are public-sector pay freezes in explaining the differential between public- and private-sector pay?
  6. Why is there a difference between the bottom and top 5% of earners? How does this impact on whether it is more profitable to work in the public or private sector?
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A 50p top tax rate: more or less money for the government?

The UK Shadow Chancellor, Ed Balls, has announced that, if Labour is returned to power in the next election, it will bring back the 50% top rate of income tax (see also). This will apply to incomes over £150,000.

But will this raise more tax revenue? The question here concerns incentive effects. Will the higher rate of income tax discourage work by those earning £150,000 or encourage tax avoidance or tax evasion, so that the total tax take is reduced? The Conservatives say the answer is yes. The Labour party says no, claiming that there will still be an increase in tax revenue.

The possible effects are summed up in the Laffer curve (see The 50p income tax rate and the Laffer curve). As the previous post stated:

These arguments were put forward in the 1980s by Art Laffer, an adviser to President Reagan. His famous ‘Laffer curve’ (see Economics (8th edition) Box 10.3) illustrated that tax revenues are maximised at a particular tax rate. The idea behind the Laffer curve is very simple. At a tax rate of 0%, tax revenue will be zero – but so too at a rate of 100%, since no-one would work if they had to pay all their income in taxes. As the tax rate rises from 0%, so tax revenue would rise. And so too, as the tax rate falls from 100%, the tax rate would rise. It follows that there will be some tax rate between 0% and 100% that maximises tax revenue.

As Labour is claiming that re-introducing the 50% top rate of income tax will increase tax revenue, the implication is that the economy is to the left of the top of the Laffer curve: that, at current level of income, the curve is still rising.

Work by HMRC, and published in the document The Exchequer effect of the 50 per cent additional rate of income tax, suggested that the previous cut in the top rate from 50% to 45% would cut revenue by around £3.5 billion if there were no incentive effect, but with the extra work that would be generated, the cut would be a mere £100 million. This implies, other things being equal, that a rise in the rate from 45% to 50% would raise only a tiny bit of extra taxes.

However, the HMRC analysis has been criticised and especially its assumptions about the incentive effects on work. Then there is the question of whether a rise in the rate from 45% to 50% would have exactly the reverse effect of a cut from 50% to 45%. And then there is the question of how much HMRC could reduce tax evasion and avoidance.

The following article from the Institute for Fiscal Studies examines the effects. However, the authors conclude that:

… at the moment, the best evidence we have still suggests that raising the top rate of tax would raise little revenue and make, at best, a marginal contribution to reducing the budget deficit an incoming government would face after the next election.

But there is also the question of equity. Putting aside the question of how much revenue would be raised, is it fair to raise the top rate of tax for those on high incomes? Would it make an important contribution to reducing inequality? This normative question lies at the heart of the different views of the world between left and right and is not a question that can be answered by economic analysis.

50p tax – strolling across the summit of the Laffer curve? Institute for Fiscal Studies, Paul Johnson and David Phillips (Jan 2014)

Questions

  1. Distinguish between tax evasion and tax avoidance.
  2. How would it be possible for a rise in tax rates to generated less tax revenue?
  3. Could policies shift the Laffer curve as opposed to merely resulting in a move along the curve?
  4. What is meant by ‘taxable income elasticity (TIE)’? What are its determinants?
  5. Is the taxable income elasticity at the top of the Laffer curve equal to, above or below zero? Explain.
  6. Why did the Office for Budget Responsibility chairman, Robert Chote, conclude that, whatever the precise answer, we were ‘strolling across the summit of the Laffer curve’?
  7. Explain why ‘there is little additional evidence to suggest that a 50p rate would raise more than was estimated by HMRC back in 2012′.
  8. What contribution can economists make to the debate on the desirability of reducing inequality?
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Time to leave GDP behind?

GDP is still the most frequently used indicator of a country’s development. When governments target economic growth as a key goal, it is growth in GDP to which they are referring. And they often make the assumption that growth in GDP is a proxy for growth in well-being. But is it time to leave GDP behind as the main indicator of national economic success? This is the question posed in the first of the linked articles below, from the prestigious science journal Nature.

As the article states:

Robert F. Kennedy once said that a country’s gross domestic product (GDP) measures “everything except that which makes life worthwhile”. The metric was developed in the 1930s and 1940s amid the upheaval of the Great Depression and global war. Even before the United Nations began requiring countries to collect data to report national GDP, Simon Kuznets, the metric’s chief architect, had warned against equating its growth with well-being.

GDP measures mainly market transactions. It ignores social costs, environmental impacts and income inequality. If a business used GDP-style accounting, it would aim to maximize gross revenue — even at the expense of profitability, efficiency, sustainability or flexibility. That is hardly smart or sustainable (think Enron). Yet since the end of the Second World War, promoting GDP growth has remained the primary national policy goal in almost every country

So what could replace GDP, or be considered alongside GDP? Should we try to measure happiness? After all, behavioural scientists are getting much better at understanding and measuring the psychology of human well-being (see the blog posts Money can’t buy me love and Happiness economics).

Or should we focus primarily on long-term issues of the sustainability of development? Or should we focus more on the distribution of income or well-being in a world that is becoming increasingly unequal?

Or should measures of well-being involve weighted composite indices involving things such as life-expectancy, education, housing, democratic engagement, leisure time, social mobility, etc. And, if so, how should the weightings of the different indicators be determined? The United Nations Development Programme (UNDP) produces annual Human Development Reports, where countries are ranked according to a Human Development Index. As the UNDP site states:

The breakthrough for the HDI was the creation of a single statistic which was to serve as a frame of reference for both social and economic development. The HDI sets a minimum and a maximum for each dimension, called goalposts, and then shows where each country stands in relation to these goalposts, expressed as a value between 0 and 1.

HDI is a composite of three sets of indicators: education, life expectancy and income (see). The UNDP since 2010 has also produced an Inequality-adjusted HDI (IHDI).

The IHDI will be equal to the HDI value when there is no inequality, but falls below the HDI value as inequality rises. The difference between the HDI and the IHDI represents the ‘loss’ in potential human development due to inequality and can be expressed as a percentage.

You can now build your own HDI for each country on the UNDP site by selecting from the following indicators: health, education, income, inequality, poverty and gender.

The Nature article considers a number of measures of progress and considers their relative merits. The other articles also look at measuring national progress and well-being and at the relationship between income per head and happiness. It is clear that focusing on GDP alone provides too simplistic an approach to measuring development.

Development: Time to leave GDP behind Nature, Robert Costanza, Ida Kubiszewski, Enrico Giovannini, Hunter Lovins, Jacqueline McGlade, Kate E. Pickett, Kristín Vala Ragnarsdóttir, Debra Roberts, Roberto De Vogli and Richard Wilkinson (15/1/14)
The happiness agenda makes for miserable policy The Conversation, Daniel Sage (9/1/14)
Economic view: No matter what the politicians say, GDP is a distorted guide to economic performance and a bad way to measure prosperity Independent, Guy Hands (28/1/14)
Buy buy love The Economist (22/6/13)
Experts confirm that money does buy happiness – but only up to £22,100 Independent, Jamie Merrill (28/11/13)
Can Money Buy Happiness? Scientific American, Sonja Lyubomirsky (10/8/10)
Money can buy happiness The Economist (2/5/13)
Money can buy happiness Hacker News, pyduan (13/1/14)
Can ‘happiness economics’ provide a new framework for development? The Guardian, Christian Kroll (3/9/13)
The 10 Things Economics Can Tell Us About Happiness The Atlantic, Derek Thompson (31/5/12)
Financial crisis hits happiness levels BBC News (3/11/13)
Happiness study finds that UK is passing point of peak life satisfaction The Guardian, Larry Elliott (27/11/13)
How GDP became the figure everyone wanted to watch BBC News, Peter Day (16/4/14)
Economic development can only buy happiness up to a ‘sweet spot’ of $36,000 GDP per person Science Daily (27/11/13)

Questions

  1. What does GDP measure?
  2. How suitable a measure of economic progress is growth in GDP?
  3. How can GDP be adjusted to make it a more suitable measure of economic progress?
  4. What are the advantages of using composite indicators of well-being?
  5. What difficulties are there in measuring well-being using composite indicators?
  6. Assuming there were no measurement problems, what indicators would you include in devising the optimum composite indicator of well-being?
  7. Can money buy happiness?
  8. Why do life satisfaction levels peak at around $36,000 (adjusted for Purchasing Power Parity (PPP))?
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Making economic sense of politicians’ statements

Politicians often make use of economic statistics to promote their point of view. A good example is a claim made by the UK Prime Minister on 23 January 2014. According to the latest statistics, he said, most British workers have seen their take-home pay rise in real terms. The Labour party countered this by arguing that incomes are not keeping up with prices.

So who is right? Studying economics and being familiar with analysing economic data should help you answer this question. Not surprisingly, the answer depends on just how you define the issue and what datasets you use.

The Prime Minister was referring to National Statistics’ Annual Survey of Hours and Earnings (ASHE). This shows that in April 2013 median gross weekly earnings for full-time employees were £517.5, up 2.25% from £506.10 in 2012, and mean gross weekly earnings for full-time employees were £620.30, up 2.06% from £607.80 in 2012 (see Table 1.1a in the dataset). CPI inflation over this period was 2.4%, representing a real fall in median gross weekly earnings of 0.15% and mean gross weekly earnings of 0.34%.

But when adjustments are made for increases in personal income tax allowances, then, according to the government, except for the richest 10% of the working population, people had an average increase in real take-home pay of 1.1%.

But does this paint the complete picture? Critics of the government’s claim that people are ‘better off’, make the following points.

First, the ASHE dataset is for the year ending April 2013. The ONS publishes other datasets that show that real wages have fallen faster since then. The Earnings and Working Hours datasets, published monthly, currently go up to November 2013. The chart shows real wages from January 2005 to November 2013 (with CPI = 100 in December 2013). You can see that the downward trend resumed after mid 2013. In the year to November 2013, nominal average weekly earnings rose by 0.9%, while CPI inflation was 2.1%. Thus real weekly earnings fell by 1.2% over the period (click here for a PowerPoint of the chart).

Second, there is the question of whether CPI or RPI inflation should be used in calculating real wages. RPI inflation was 2.9% (compared to CPI inflation of 2.4%) in the year to April 2013. The chart shows weekly earnings adjusted for both CPI and RPI.

Third, if, instead of looking at gross real wages, the effect of income tax and national insurance changes are taken into account, then benefit changes ought also to be taken into account. Some benefits, such as tax credits and child benefit were cut in the year to April 2013.

Fourth, looking at just one year (and not even the latest 12 months) gives a very partial picture. It is better to look at a longer period and see what the trends are. The chart shows the period from 2005. Real wages (CPI adjusted) are 8.0% lower than at the peak (at the beginning of 2009) and 5.0% lower than at the time of the election in 2010. The differences are even greater if RPI-adjusted wages are used.

But even if the claim that real incomes are rising is open to a number of objections, it may be that as the recovery begins to gather pace, real incomes will indeed begin to rise. But to assess whether this is so will require a careful analysis of the statistics when they become available.

Articles
UK pay rising in real terms, says coalition BBC News (24/1/14)
Are we really any better off than we were? BBC News, Brian Milligan (24/1/14)
Government take-home pay figures ‘perfectly sensible’ BBC Today Programme, Paul Johnson (24/1/14)
Take-Home Pay ‘Rising Faster Than Prices’ Sky News, Darren McCaffrey (25/1/14)
David Cameron hails the start of ‘recovery for all’ The Telegraph, Peter Dominiczak (23/1/14)
Is take-home pay improving? The answer is anything but simple The Guardian, Phillip Inman and Katie Allen (24/1/14)
Cameron’s ‘good news’ about rising incomes is misleading says Labour The Guardian, Rowena Mason (24/1/14)
The Tories’ claim that living standards have risen is nonsense on stilts New Statesman, George Eaton (24/1/14)
FactCheck: Conservative claims on rising living standards Channel 4 News, Patrick Worrall (25/1/14)
Living standards squeeze continues in UK, says IFS BBC News (31/1/14)
Richest have seen biggest cash income squeeze but poorest have faced higher inflation IFS Press Release (31/1/14)

Data
Average Weekly Earnings dataset ONS (22/1/14)
Annual Survey of Hours and Earnings, 2013 Provisional Results ONS (12/12/13)
Consumer Price Inflation, December 2013 ONS (14/1/14)
Inequality and Poverty Spreadsheet Institute for Fiscal Studies
An Examination of Falling Real Wages, 2010 to 2013 ONS (31/1/14)

Questions

  1. Why are mean weekly earnings higher than median weekly earnings?
  2. Explain the difference between RPI and CPI. Which is the more appropriate index for determining changes in real incomes?
  3. Find out what benefit changes have taken place over the past two years and how they have affected household incomes.
  4. How have gross weekly earnings changed for the different income groups? (The ASHE gives figures for decile groups.)
  5. Which is better for assessing changes in incomes: weekly earnings or hourly earnings?
  6. How would you define a change in living standards? What data would you need to be able to assess whether living standards have increased or decreased?
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Effects of raising the minimum wage

Conservative Party leaders are considering the benefits of an above-inflation rise in the minimum wage. This policy has been advocated by both the Labour Party and the Liberal Democrats as a means of helping the lowest paid workers. From 2008 to 2013, minimum wage rates fell 5.2% in real terms: in other words, nominal increases were less than the increase in both the RPI and CPI (see UK minimum wage: a history in numbers).

Advocates of a real rise in the minimum wage argue that not only would it help low-paid workers, many of whom are in severe financial difficulties, but it would benefit the Treasury. According to Policy Exchange, a free-market think tank closely aligned to the Conservative Party, increasing the minimum wage by 50p would save the Government an estimated £750m a year through higher tax revenues and lower benefit payments.

But even such a rise to £6.81 would still leave the minimum wage substantially below the living wage of £8.80 in London and £7.65 in the rest of the UK, as estimated by the Living Wage Foundation (see The cost of a living wage). Although many businesses are now paying at least the living wage, many others, especially small businesses, argue that a rise in the minimum wage above the rate of inflation would force them to consider cutting the number of employees or reducing hours for part-time workers.

Meanwhile, in the USA 13 states have raised their minimum wage rates from the 1st January 2014 (see). Some of the rises, however, were tiny: as little as 15 cents. In a couple of cases, the rise is $1. Currently 21 states and DC have minimum wage rates above the Federal level of $7.25 (approx. £4.40); 20 states have rates the same as the Federal level; 4 states have rates below the Federal level. At $9.32 per hour, Washington State has the highest state minimum wage; the lowest rates ($5.15) are in Georgia and Wyoming. In 5 states there is no minimum wage at all. As the ABC article below states:

The piecemeal increases at the local level are occurring amidst a national debate over low wages and income inequality. Fast food and retail workers have been staging protests and walking off work for more than a year, calling for better pay and more hours. Currently, fast food workers nationally earn an average of about $9 per hour.

Workers from McDonald’s, Wendy’s, Burger King and other fast food joints are calling for $15 per hour. Wal-Mart workers organizing as part of the union-backed OUR Walmart aren’t asking for a specific dollar amount increase, but they say it’s impossible to live on the wages they currently receive.

President Obama has been throwing his weight behind the issue. Earlier this month, the President said in a speech that it’s “well past the time to raise the minimum wage that in real terms right now is below where it was when Harry Truman was in office.” But such legislation has a bleaker outlook if it reaches the Republican-led House of Representatives. House Speaker John Boehner has said that raising the minimum wage leads to a pullback in hiring.

So what are the costs and benefits of a significant real rise is the minimum wage on either side of the Atlantic? The articles explore the issues.

Articles: UK
Lib Dems accuse Tories of ‘stealing’ their policy as George Osborne prepares to approve above-inflation rise in minimum wage Independent, Andrew Grice (7/1/14)
Lib Dems accuse Tories of ‘nicking’ party’s policy on low wages The Guardian, Nicholas Watt (7/1/14)
Cut housing benefit? A higher minimum wage would help The Guardian, Patrick Collinson (6/1/14)
Miliband prepares to wage war The Scotsman, Andrew Whitaker (8/1/14)
Increasing the minimum wage is only a half answer to poverty New Statesman, Helen Barnard (8/1/14)
Raise the bar: Economically and socially, Britain needs higher wages Independent (7/1/14)
Another Tory says there’s a ‘strong case’ for raising the minimum wage The Spectator, Isabel Hardman (8/1/14)
Fairness and the minimum wage Financial Times (7/1/14)
Osborne wants above-inflation minimum wage rise BBC News (16/1/14)
George Osborne backs minimum wage rise to £7 an hour The Guardian, Nicholas Watt, (16/1/14)
Minimum wage: in his efforts to defeat Labour, Osborne risks mimicking them The Telegraph, Benedict Brogan (16/1/14)
Minimum wage announcement is not just good economics The Guardian, Larry Elliott (16/1/14)

Articles: USA
13 states raising pay for minimum-wage workers USA Today, Paul Davidson (30/12/13)
Minimum wage increase: Wage to rise in 13 states on Jan. 1 ABC15 (30/12/13)
NJ minimum wage sees $1 bump on Jan. 1 Bloomberg Businessweek, Angela Delli Santi (31/12/13)
Minimum wage hike a job killer ctpost, Rick Torres (7/1/14)
A Business Owners Case For Raising The Minimum Wage Grundy Country Herald, David Bolotsky (7/1/14)
Raising the Minimum Wage Isn’t Just Good Politics. It’s Good Economics, Too. New Republic, Noam Scheiber (31/12/13)
Minimum wage rises across 13 US states Financial Times, James Politi (1/1/14)

Information
National Minimum Wage rates GOV.UK
UK minimum wage: a history in numbers Guardian Datablog
List of minimum wages by country Wikipedia

Questions

  1. Draw two diagrams to demonstrate the direct microeconomic effect of a rise in the minimum wage for two employers, both currently paying the minimum wage, where the first is operating in an otherwise competitive labour market and the other is a monopsonist.
  2. What is meant by the term ‘efficiency wage rate’? How is the concept relevant to the debate about the effects of raising the minimum wage rate?
  3. What are the likely macroeconomic effects of raising the minimum wage rate?
  4. What is the likely impact of raising the minimum wage rate on public finances?
  5. Is raising the minimum wage rate the best means of tackling poverty? Explain your answer.
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