The housing sector is now (September 2007) at the root of three distinct but related problems: (1) a sharp decline in house prices and the related fall in home building; (2) a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets; and (3) a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending. Each of these could by itself be powerful enough to cause an economic downturn. The combination could cause a very serious recession unless there are other offsetting forces. In this paper, I discuss each of these and then comment on the implications for monetary policy.
The ageing of the population presents a major fiscal challenge for the countries of Europe. The combination of increased longevity and a reduced birth rate will directly reduce the growth rates of the European economies by slowing the growth of the capital stock and by weakening the productivity of the labor force. This slower growth of GDP means a smaller tax base and less tax revenue. In addition, the current tax-financed systems of social pensions and health care will require substantial increases in the already high tax rates. The analysis in this paper shows that the common prescription of increased immigration would do little to reduce the future fiscal burden. The increased revenue from a large rise in immigration would finance only a small part of the coming rise in the cost of pension and health benefits. The only alternative to significantly higher tax rates or substantially lower retirement income is to shift from a pure tax-financed system to a mixed system that supplements the tax financed benefits with benefits based on increased saving financial investment.
A desirable system for providing and financing health care would achieve three goals: (1) preventing the deprivation of care because of a patient's inability to pay; (2) avoiding wasteful spending; and (3) allowing care to reflect the different tastes of individual patients. Although it is not possible to realize fully all three of these goals, they can condition and inform the design of a good system for financing health care. This paper discusses the application of these goals in more detail and use them to consider a reform of the system of Health Savings Accounts that was enacted as part of the 2003 Medicare legislation and, separately, the challenge posed by the very expensive treatments for rare diseases that are becoming more common.
This nontechnical paper discusses the adverse effects of high marginal tax rates on labor income and on investment income. It explains that the deadweight loss of a tax on labor income depends on the response of taxable income and not just the change in labor supply. An across the board increase in personal tax rates involves a deadweight loss of 76 cents per dollar of revenue and only collects about two-thirds of the revenue implied by a “static” calculation.
A tax on investment income brings a deadweight loss even if household saving does not respond to taxes and the net rate of return. What matters is the response of future consumption. The tax on investment income is also effectively a tax on labor supply because current work effort produces income that will be spent on future consumption and the tax on investment income reduces the future consumption that results from more work today.
An appendix shows for a simple log utility case that the tax on labor income has a smaller deadweight loss than a tax on investment income with the same present value of revenue.
There is a further discussion of the various ways in which capital income taxes distort economic activity.
This paper is an analytic comment on two chapters of the Economic Report of the President for 2006. Chapter One deals with the economy in 2005 and the outlook for the future. The chapter provides a detailed analysis of the expansion in 2005 but not an explanation of why the expansion occurred despite the sharp rise in oil prices. I discuss the role of easy money in stimulating mortgage borrowing which generated negative savings in 2005. Looking ahead, I comment on the risk to inflation implied by the rising unit labor costs over the past four years. Chapter six deals with the international position of the United States. It provides a useful analysis of capital flows to the United States and the reasons why other countries have current account surpluses. It does not deal with the role of the dollar or the nature of the adjustment that might occur to reduce the US current account deficit. I present some comments on those issues.
The Feldstein-Horioka study of 1980 found that OECD countries with high saving rates had high investment rates and vice versa, contrary to the traditional theory of global capital market integration. This capital market segmentation view, which has been verified in various studies over the past several decades, has important implications for tax and monetary policy.
More recently, Alan Greenspan and John Helliwell have shown that the link between domestic saving and domestic investment became substantially weaker after the mid-1990s. The research reported in the current paper suggests that this is true of the smaller OECD countries but not of the larger ones. When observations are weighted by each country's GDP, the savings-investment link (i.e., the savings retention coefficient) remains relatively high.
This paper also examines the recent capital flows to the United States. The Treasury International Capital (TIC) reports are generally misunderstood. When they are properly interpreted, they do not indicate that they U.S. has an excess of capital flows to finance the current account deficit. The TIC data also cannot be relied on the distinguish private and government sources of the capital flow. The persistence of these flows is therefore uncertain.
The paper discusses the implications for monetary and fiscal policy of the changes in capital flows that may be happening.
We examine a system of Unemployment Insurance Saving Accounts (UISAs) as an alternative to the traditional unemployment insurance system. Individuals are required to save up to 4 percent of wages in special accounts and to draw unemployment compensation from these accounts instead of taking state unemployment insurance benefits. If the accounts are exhausted, the government lends money to the account. Positive accounts earn the return on commercial paper and negative accounts are charged that rate. Positive UISA balances are converted into retirement income or bequeathed if the individual dies before retirement age. Negative account balances are forgiven at retirement age. Money taken by an unemployed individual from a UISA with a positive balance reduces the individual's personal wealth by an equal amount. In this case, individuals fully internalize the cost of unemployment compensation. UISAs provide the same protection to the unemployed as the current UI system but with less of the adverse incentives. The key empirical question is whether accounts based on a moderate saving rate can finance a significant share of unemployment payments or whether the concentration of unemployment among a relatively small number of individuals implies that the UISA balances would typically be negative, forcing individuals to rely on government benefits with the same adverse effects that characterize the current UI system. To resolve this issue we use the Panel Study on Income Dynamics to simulate the UISA system over a 25 year historic period. Our analysis indicates that almost all individuals have positive UISA balances and therefore remain sensitive to the cost of unemployment compensation. Even among individuals who experience unemployment, most have positive account balances at the end of their unemployment spell. Although about half of the benefit dollars would go to individuals whose accounts are negative at the end of their working life, less than one third of the benefits go to individuals who also have negative account balances when unemployed. These facts suggest a substantial potential improvement in the incentives of the unemployed. The cost to taxpayers of forgiving the negative balances is substantially less than half of the taxpayer cost of the current UI system. Our analysis of the distribution of lifetime UISA payments and taxes of household heads shows the top quintile gaining a small cumulative amount while those in the bottom quintile lose a very small cumulative amount. Other quintiles are small net gainers.
This paper begins by discussing the inherent conflict between the simultaneous existence of a single currency for the countries of the European Economic and Monetary Union (EMU) and the independent fiscal policies of those countries. The Stability and Growth Pact was an attempt to reconcile that conflict. I describe how EMU governments have chosen to ignore the Stability Pact's constraint on budget deficits and how they sought to undermine it by changing the rules themselves. The final part of the paper describes the actual resolution of the issue by the agreement reached at the end of March 2005 by the European Council. The new policy effectively abandons the Stability Pact and leaves the way open to much larger sustained deficits.
Governments around the world have enacted or are currently considering fundamental structural reforms of their Social Security pension programs. The key feature in these reforms is a shift from a pure pay-as-you-go tax-financed system, in which taxes on current workers are primarily distributed to current retirees, to a mixed system that combines pay-as-you-go benefits with investment-based personal retirement accounts.
This paper discusses how such a mixed system could work in practice and how the transition to such a change could be achieved. It then analyzes the economic gains that would result from shifting to a mixed system. I turn next to the three problems that critics raise about any investment-based plan: administrative costs, risk, and income distribution. Finally, I comment on some of the ad hoc proposals for dealing with the financial problem of Social Security without shifting to an investment-based system.
This paper begins by discussing the nature of and rationale for social insurance programs. I then consider three political principles and four economic principles that could guide the design and reform of social insurance programs. These ideas are then applied to unemployment insurance, Social Security pensions, health insurance and Medicare. A common theme is the advantage of incorporating investment based personal accounts in each of these programs.