The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.
While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.
The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth
The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.
An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.
The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.
The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.
In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.
But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!
Videos
Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)
Articles
Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)
IMF Fiscal Monitor
IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)
Questions
- Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
- What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
- Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
- Why may governments reject the IMF’s policy recommendations to tackle inequality?
- In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
- Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
- What does the IMF report suggest about the shape of the Laffer curve?
- Explain what is meant by tax elasticity and how it relates to the Laffer curve?
On the 15th June, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate on hold at its record low of 0.25%. This was not a surprise – it was what commentators had expected. What was surprising, however, was the split in the MPC. Three of its current eight members voted to raise the rate.
At first sight, raising the rate might seem the obvious thing to do. CPI inflation is currently 2.9% – up from 2.7% in April and well above the target of 2% – and is forecast to go higher later this year. According to the Bank of England’s own forecasts, even at the 24-month horizon inflation is still likely to be a little above the 2% target.
Those who voted for an increase of 0.25 percentage points to 0.5% saw it as modest, signalling only a very gradual return to more ‘normal’ interest rates. However, the five who voted to keep the rate at 0.25% felt that it could dampen demand too much.
The key argument is that inflation is not of the demand-pull variety. Aggregate demand is subdued. Real wages are falling and hence consumer demand is likely to fall too. Thus many firms are cautious about investing, especially given the considerable uncertainties surrounding the nature of Brexit. The prime cause of the rise in inflation is the fall in sterling since the Brexit vote and the effect of higher import costs feeding through into retail prices. In other words, the inflation is of the cost-push variety. In such cirsumstances dampening demand further by raising interest rates would be seen by most economists as the wrong response. As the minutes of the MPC meeting state:
Attempting to offset fully the effect of weaker sterling on inflation would be achievable only at the cost of higher unemployment and, in all likelihood, even weaker income growth. For this reason, the MPC’s remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity.
The MPC recognises that the outlook is uncertain. It states that it stands ready to respond to circumstances as they change. If demand proves to be more resilient that it currently expects, it will raise Bank Rate. If not, it is likely to keep it on hold to continue providing a modest stimulus to the economy. However, it is unlikely to engage in further quantitative easing unless the economic outlook deteriorates markedly.
Articles
The Bank of England is moving closer to killing the most boring chart in UK finance right now Business Insider, Will Martin (16/6/17)
UK inflation hits four-year high of 2.9% Financial Times, Gavin Jackson and Chloe Cornish (13/6/17)
Surprise for markets as trio of Bank of England gurus call for interest rates to rise The Telegraph, Szu Ping Chan Tim Wallace (15/6/17)
Bank of England rate setters show worries over rising inflation Financial TImes, Chris Giles (15/6/17)
Three Bank of England policymakers in shock vote for interest rate rise Independent, Ben Chu (15/6/17)
Bank of England edges closer to increasing UK interest rates The Guardian, Katie Allen (15/6/17)
Bank of England doves right to thwart hawks seeking interest rate rise The Guardian, Larry Elliott (15/6/17)
Haldane expects to vote for rate rise this year BBC News (21/6/17)
Bank of England documents
Monetary policy summary Bank of England (15/6/17)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 14 June 2017 Bank of England (15/6/17)
Inflation Report, May 2017 Bank of England (11/5/16)
Questions
- What is the mechanism whereby a change in Bank Rate affects other interest artes?
- Use an aggregate demand and supply diagram to illustrate the difference between demand-pull and cost-push inflation.
- If the exchange rate remains at around 10–15% below the level before the Brexit vote, will inflation continue to remain above the Bank of England’s target, or will it reach a peak relatively soon and then fall back? Explain.
- For what reason might aggregate demand prove more buoyant that the MPC predicts?
- Would a rise in Bank Rate from 0.25% to 0.5% have a significant effect on aggregate demand? What role could expectations play in determining the nature and size of the effect?
- Why are real wage rates falling at a time when unemployment is historically very low?
- What determines the amount that higher prices paid by importers of products are passed on to consumers?
With the effects of the depreciation of sterling feeding through into higher prices, so the rate of inflation has risen. The latest figures from the ONS show that in the year to April 2017, CPI inflation was 2.7% – up from 2.3% in the year to March. The largest contributors to higher prices were transport costs and housing and household services.
But wage increases are not keeping up with price increases. In 2017 Q1, the average annual growth rate in regular pay (i.e. excluding bonuses) was 2.1%. In other words, real pay is falling. And this is despite the fact that the unemployment rate, at 4.6%, is the lowest since 1975.
The fall in real wages is likely to act as a brake on consumption and the resulting dampening of aggregate demand could result in lower economic growth. On the other hand, the more buoyant world economy, plus the lower sterling exchange rate is helping to boost exports and investment and this could go some way to offsetting the effects on consumption. As Mark Carney stated in his introductory remarks to the May 2017 Bank of England Inflation Report:
The combination of the stronger global outlook and sterling’s past depreciation is likely to support UK net trade. And together with somewhat lower uncertainty, stronger global growth is also likely to encourage investment as exporters renew and increase capacity.
According to the Bank of England, the net effect will be modest economic growth, despite the fall in real wages.
In the MPC’s central forecast, quarterly growth is forecast to stabilise around its current rate, resulting in growth of 1.9% in 2017 and around 1¾% in each of the next two years.
But forecasting is dependent on a range of assumptions, not least of which are assumptions about consumer and business expectations. These, in turn, depend on a whole range of factors, such as the outcome of the UK election, the Brexit negotiations, commodity prices, world growth rates and international events, such as the actions of Donald Trump. Because of the uncertainty surrounding forecasts, the Bank of England uses fan charts. In the two fan charts illustrated below (from the May 2017 Inflation Report), the bands on constructed on the following assumptions:
If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that CPI inflation or the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions and within each pair of the lighter coloured areas on 30 occasions.
The charts and tables showing the May 2017 projections have been conditioned on the assumptions that the stock of purchased gilts remains at £435 billion and the stock of purchased corporate bonds remains at £10 billion throughout the forecast period, and on the Term Funding Scheme (TFS); all three of which are financed by the issuance of central bank reserves. They have also been conditioned on market interest rates, unless otherwise stated.
The wider the fan, the greater the degree of uncertainty. These fan charts are wide by historical standards, reflecting the particularly uncertain future for the UK economy.
But one thing is clear from the latest data: real incomes are falling. This is likely to dampen consumer spending, but just how much this will impact on aggregate demand over the coming months remains to be seen.
Articles
UK real wages drop for first time in three years Financial Times, Sarah O’Connor (17/5/17)
Bank of England warns Brexit vote will damage living standards The Guardian, Katie Allen (11/5/17)
UK wage growth lags inflation for first time since mid-2014 BBC News (17/5/17)
Britons’ Falling Real Wages Show Challenging Times Have Arrived Bloomberg, Scott Hamilton and Lucy Meakin (17/5/17)
Jobs market will suffer a Brexit slowdown, say experts The Guardian, Angela Monaghan and Phillip Inman (15/5/17)
Pay will continue to be squeezed, employers’ survey suggests BBC News, Kamal Ahmed (15/5/17)
Brexit latest: Real wages falling, Office for National Statistics reveals Independent, Ben Chu (17/5/17)
UK inflation climbs to four-year high, beating forecasts Financial Times, Gavin Jackson (16/5/17)
Why is UK inflation at a four-year high? Financial Times, Gavin Jackson (19/5/17)
A blip, or a test of hawks’ patience? Economists respond to high UK inflation data Financial Times, Nicholas Megaw (16/5/17)
UK inflation rate at highest level since September 2013 BBC News (16/5/17)
Inflation jumps to its highest level since 2013 as Brexit continues to bite Business Insider, Will Martin (16/5/17)
UK GDP growth weaker than expected as inflation hits spending The Guardian, Katie Allen (25/5/17)
UK economic growth estimate revised down BBC News (25/5/17)
Reports
Inflation Report, May 2017 Bank of England (11/5/17)
Labour Market Outlook, Sping 2017 Chartered Institute of Personnel and Development (May 2017)
Data
Statistical Interactive Database – interest & exchange rates data Bank of England
Inflation and price indices ONS
Earnings and working hours ONS
Second estimate of GDP: Jan to Mar 2017 ONS Statistical Bulletin (25/5/17)
Questions
- Find out what has happened to the dollar/sterling and the euro/sterling exchange rate and the sterling exchange rate index over the past 24 months. Plot the data on a graph.
- Explain the changes in these exchange rates.
- Why is there negative real wage growth in the UK when the rate of unemployment is the lowest it’s been for more than 40 years?
- Find out what proportion of aggregate demand is accounted for by household consumption. Why is this significant in understanding the likely drivers of economic growth over the coming months?
- Why is uncertainty over future UK growth rates relatively high at present?
- Why is inflation likely to peak later this year and then fall?
- What determines the size and shape of the fan in a fan chart?
One of President Trump’s main policy slogans has been ‘America first’. As Trump sees it, a manifestation of a country’s economic strength is its current account balance. He would love the USA to have a current account surplus. As it is, it has the largest current account deficit in the world (in absolute terms) of $481 billion in 2016 or 2.6% of GDP. This compares with the UK’s $115bn or 4.4% of GDP. Germany, by contrast, had a surplus in 2016 of $294bn or 8.5% of GDP.
However, he looks at other countries’ current account surpluses suspiciously – they may be a sign, he suspects, of ‘unfair play’. Germany’s surplus of over $50bn with the USA is particularly in his sights. Back in January, as President-elect, he threatened to put a 35% tariff on imports of German cars.
In practice, Germany is governed by eurozone rules, which prevent it from subsidising exports. And it does not have its own currency to manipulate. What is more, it is relatively open to imports from the USA. The EU imposes an average tariff of just 3% on US imports and importers also have to add VAT (19% in the case of Germany) to make them comparably priced with goods produced within the EU.
So why does Germany have such a large current account surplus? The article below explores the question and dismisses the claim that it’s the result of currency manipulation or discrimination against imports. The article states that the reason for the German surplus is that:
… it saves more than it invests. The correspondence of savings minus investment with exports minus imports is not an economic theory; it’s an accounting identity. Germans collectively spend less than they produce, and the difference necessarily shows up as net exports.
But why do the Germans save so much? The answer given is that, with an aging population, Germans are sensibly saving now to support themselves in old age. If Germany were to reduce its current account surplus, this would entail either the government reducing its budget surplus, or people reducing the amount they save, or some combination of the two. This is because a current account surplus, which consists of exports and other incomes from abroad (X) minus imports and any other income flowing abroad (M), must equal the surplus of saving (S) plus taxation (T) over investment (I) plus government expenditure (G). In terms of withdrawals and injections, given that:
I + G + X = S + T + M
then, rearranging the terms,
X – M = (S + T) – (I + G).
If German people are reluctant to reduce the amount they save, then an alternative is for the German government to reduce taxation or increase government expenditure. In the run-up to the forthcoming election on 24 September, Chancellor Merkel’s centre-right CDU party advocates cutting taxes, while the main opposition party, the SPD, advocates increasing government expenditure, especially on infrastructure. The article considers the arguments for these two approaches.
Article
The German economy is unbalanced – but Trump has the wrong answer The Guardian, Barry Eichengreen (12/5/17)
Data
German economic data (in English) Statistisches Bundesamt (Federal Statistical Office)
World Economic Outlook Databases IMF
Questions
- Why does Germany have such a large current account surplus?
- What are the costs and benefits to Germany of having a large current account surplus?
- What is meant by ‘mercantilism’? Why is its justification fallacious?
- If Germany had its own currency, would it be a good idea for it to let that currency appreciate?
- What are meant by ‘resource crowding out’ and ‘financial crowding out’? Why might the policies of tax cuts advocated by the CDU result in crowding out? What form would it take and why?
- Compare the relative benefits of the policies advocated by the CDU and SPD to reduce Germany’s budget surplus.
- Would other countries, such as the USA, benefit from a reduction in Germany’s current account surplus?
- Is what ways would the USA gain and lose from restricting imports from Germany? Would it be a net gain or loss? Explain.
Both the financial and goods markets are heavily influenced by sentiment. And such sentiment tends to be self-reinforcing. If consumers and investors are pessimistic, they will not spend and not invest. The economy declines and this further worsens sentiment and further discourages consumption and investment. Banks become less willing to lend and stock markets fall. The falling stock markets discourage people from buying shares and so share prices fall further. The despondency becomes irrational and greatly exaggerates economic fundamentals.
This same irrationality applies in a boom. Here it becomes irrational exuberance. A boom encourages confidence and stimulates consumer spending and investment. This further stimulates the boom via the multiplier and accelerator and further inspires confidence. Banks are more willing to lend, which further feeds the expansion. Stock markets soar and destabilising speculation further pushes up share prices. There is a stock market bubble.
But bubbles burst. The question is whether the current global stock market boom, with share prices reaching record levels, represents a bubble. One indicator is the price/earnings (PE) ratio of shares. This is the ratio of share prices to earnings per share. Currently the ratio for the US index, S&P 500, is just over 26. This compares with a mean over the past 147 years of 15.64. The current ratio is the third highest after the peaks of the early 2000s and 2008/9.
An alternative measure of the PE ratio is the Shiller PE ratio (see also). This is named after Robert Shiller, who wrote the book Irrational Exuberance. Unlike conventional PE ratios, which only look at average earnings over the past four quarters, the Shiller PE ratio uses average earnings over the past 10 years. “Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year.”
The current level of the Shiller PE ratio is 29.14, the third highest on record, this time after the period running up to the Wall Street crash of 1929 and the dot-com bubble of the late 1990s. The mean Shiller PE ratio over the past 147 years is 16.72.
So are we in a period of irrational exuberance? And are stock markets experiencing a bubble that sooner or later will burst? The following articles explore these questions.
Articles
2 Clear Instances of Irrational Exuberance Seeking Alpha, Jeffrey Himelson (12/2/17)
Promised land of Trumpflation-inspired global stimulus has been slow off the mark South China Morning Post, David Brown (20/2/17)
A stock market crash is a way off, but this boom will turn to bust The Guardian, Larry Elliott (16/2/17)
The “boring” bubble is close to bursting – the Unilever bid proves it MoneyWeek, John Stepek (20/2/17)
Questions
- Find out what is meant by Minksy’s ‘financial instability hypothesis’ and a ‘Minsky moment’. How might they explain irrational exuberance and the sudden turning point from a boom to a bust?
- Is it really irrational to buy shares with a very high PE ratio if everyone else is doing so?
- Why are people currently exuberant?
- What might cause the current exuberance to end?
- How does irrational exuberance affect the size of the multiplier?
- How might the behaviour of banks and other financial institutions contribute towards a boom fuelled by irrational exuberance?
- Compare the usefulness of a standard PE ratio with the Shiller PE ratio.
- Other than high PE ratios, what else might suggest that stock markets are overvalued?
- Why might a company’s PE ratio differ from its price/dividends ratio (see)? Which is a better measure of whether or not a share is overvalued?
An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.
