Monday, January 30, 2012

Why Mankiw is wrong, and so is Krugman…

After a long period of letting things slide, this fascinating discussion on taxes compels me to get involved. Not for lack of quality contribution to the discussion – the best of the best have spoken, but because the discussion seems to be focused on the wrong problem.

A lot of comment has focused on tax on investment income vis-à-vis tax on ‘normal’ income and the reasons why it differs to the extent that it does. Investment income or ‘capital gains’ are typically taxed at a rate lower than that on ‘normal’ income. As a result, those who derive any part of their income from investments pay a lower average rate of tax on their total income than those who don’t. When seen alongside the fact that those deriving investment income are typically wealthier than those who don’t, and the share of investment income typically increases with income, this is easily seen as a regime that favours rich over poor. Those who oppose it, like Paul Krugman, claim it contributes to increasing inequality by allowing the rich to retain more of their income. Those who oppose it, like Greg Mankiw and Donald Boudreaux, claim that since investment income represents post tax corporate income, the proportion of tax paid by those who derive it should be seen as the sum of the corporate tax rate and the justifiably lower ‘capital gains’ tax rate, which is higher than the tax rate for ‘normal’ income. On the face of it, both positions seem intuitively correct.

However, the issue is not about rich and poor, investment income & normal income, corporate taxes & individual taxes or even about progressive taxation. Its about the distinction between income and savings.

Apart from wages, every other source of income is taxed on the savings it generates. Individual entrepreneurs, businesses and corporations pay tax only on the portion of their income that is saved after all expenses required to earn that income have been deducted. These savings are called profits. Wage earners, on the other hand are taxed on total income, at roughly the same rate paid by all other entities on profits, with a few deductions thrown in to give a semblance of equity to the regime.

Seen from another perspective, except for expenses incurred by wage earners, deductible expenses for one entity are revenues for another. Whether its a professional speaker paying for airfare and accommodation while on a speaking assignment, or a business paying rent for the property it occupies, or a corporation paying telephone bills, the recipient entity accounts for the inflow as a revenue. As mentioned above, it then deducts all expenses incurred by it and pays tax on what remains, while wage earners pay tax on all they receive. But more importantly, when wage earners spend money on food, healthcare, clothing and housing, recipient entities have to account for the inflow as a receipt and pay tax on the profit it generates despite the fact that the wage earner is incurring this expenditure from after-tax income.

The issue at hand is not about favouring the rich, its about disfavouring wage earners regardless of their level of income. This discussion has emotional appeal for the US and other developed nations since a sizeable proportion their population consists of wage earners. However, their angst is not because others gets to keep more of their income. Its because they get to keep so little.

Monday, October 24, 2011

Why interest rates will rise... And inflation too.

It's policy time again and as usual, speculation about the RBI's stance later today is more than rife. Some commentators feel that the RBI has hiked rates enough. Others feel that more hikes are warranted as inflation continues to remain at ridiculously high levels. Both sides, however, fail to provide for the anomalies of the Indian economy and suitability of traditional policy instruments to the task at hand.

Theoretically, when faced with high inflation, a central bank hikes interest rates which serves to reduce inflation in two ways. Firstly, higher interest rates suppress domestic demand which robs local businesses of pricing power. Reduced domestic demand also reduces the quantum of imports which results in improved balance of payments and currency appreciation. This, in turn, lowers the price of imported goods with it's consequent salutary impact on inflation.

Secondly, in an open economy, higher interest rates attract foreign capital which results in currency appreciation and hence, lower prices for imported goods which in turn serves to ease inflationary pressures. This impact, however, can manifest only when the country in question has an open capital account for debt flows.

When analyzing the applicability of these theoretical outcomes to India, one is immediately aware of a critical gap. India's capital account is completely open only for equity flows, not debt flows. As a result, higher interest rates are seldom accompanied by greater inflows of foreign capital. In fact, as higher interest rates squeeze domestic economic activity and corporate profitability, foreign equity flows reduce or even reverse. This worsens the balance of payments and can, and frequently does, result in currency depreciation at such times. As the currency depreciates, the prices of imported goods rise which adds to inflationary pressures rather than easing them. This makes it extremely likely that in India, with the existing framework, higher interest rates will cause higher inflation rather than combatting it.

Recent evidence supports this theory almost completely. For the second time in the last 4 years one can witness the currency collapsing and inflation increasing as interest rates rise. When inflation subsided somewhat in 2008/2009 as international commodity prices crashed it gave the RBI the unfortunate impression of a monetary policy success. With the RBI looking to replicate this 'success' once again, it is more than likely that interest rates will rise once again later today. And in the absence of a complete collapse in international commodity prices, so will inflation.

Thursday, April 7, 2011

An update and some links

Hey all,

Its been a hell of a long time since I last wrote and that’s probably because its been a while since I actually read real world economics and not a text book.  And while I was tempted to write about what I was learning, it always turned out too bookish to be a blog post. So many posts were started and abandoned, some forever, and some which I may revive when the opportunity presents itself.

As things stand at the moment, I may be in a position to get back to reading up on real world economics and once I am up to steam on what I have missed, writing again. It shouldn’t take too long; not much has changed except for my perception. So to ease into it, I’ll be sharing the most interesting facts and perspectives I come across for the next few days. So here goes,

A market for everything – Meteorite fragments for sale!!

An experiment in parking charges – on the right track, but will it work?

How the world’s economic centre of gravity is shifting.

$1,700: The annual benefit the average American derives from personal computers – Just a thought on pricing, though. It seems Apple would like to corner most of this benefit, which makes the net benefit to a Mac owner much lower than that of an average PC owner… Hmmm…

Don Boudreaux; Trade & Borders – Just one of his endless rants… My comment is numbered 14th…

Don Boudreaux: Costs are not benefits – Of course they aren’t! My comment is numbered 12th… and for a more well thought out point of view, read this (pdf)

And finally, via Greg Mankiw


Click on image to enlarge

Saturday, February 12, 2011

Rejoice for Egypt; Lament for India

So after 18 days of protest, Egypt is free from a dictator who ruled for 30 years. Its time for Egypt to rejoice, despite the uncertainty of how the Army will behave in coming days. But this event only makes the situation in India worthier of a lament.

The current Prime Minister is an honest man. But his incompetence in managing government becomes clearer with every passing day. From the Commonwealth Games, the Telecom Scam to S- bandwidth for ISRO, he has the singular honor of heading a government which has cheated the people of India out of more than the year's fiscal deficit.  An amount roughly 5,500 times that involved in the infamous Bofors scam which, unfortunately, we still find time to discuss. An amount which could retire close to 10% of the government's outstanding liabilities.

He also has the honor of presiding over the sharpest increase in basic food prices in more than a decade; an increase that drove millions back into poverty as they realized that feeding a family took far more than just honest hard work. 

Of course, it isn't the Prime Minister's fault. He's an honest man forced to make compromises in managing a coalition government. So the telecom scam satisfies the lust of one ally and food price increases purify the cancerous blood of another. And while they were at it, one needed to be fair to one's own party as well, which was served well by the Commonwealth Games and S-Band allocation.

Yet it is Egypt which has the opportunity to protest & overthrow an entrenched dictator and rejoice when the will of the people prevails. We have been taught to believe that our government is the will of the people. but is it, really? 

Do we really elect governments with a mandate to loot the nation? To enrich themselves while millions suffer.  Is this what democracy is supposed to be? Is this the will of our nation?

Friday, October 29, 2010

Apologies and an update...

Firstly, my apologies for having been delinquent over the last couple of months... It wasn't intentional, but then again, that isn't an excuse.

The fact of the matter is, that after a lot of thinking, I reached a really difficult and in some ways, heart-rending decision. I decided to study further.

Of the many reasons behind this decision, one really stands out in importance. After having experienced economics as a practitioner, my lack of formal training and consequently, inability to pursue some thoughts to their logical conclusion was bothersome. Since this could only be corrected by training, I decided to look for an appropriate course.

Of the many options available nowadays, the one that really stood out was the MSc in Economic Management & Policy at the University of Strathclyde, Glasgow. It taught theory with a practical orientation, something I thought I would be better placed to cope with than a dedicatedly theoretical course. Entering the classroom as a student after 20 years was a scary thought, but it was worth a shot.

Little did I realise that it isn't the environment that matters. What does matter is one's attention span, which after having spent 15 years in the high intensity financial services industry, is slightly over 5 seconds per task.

In a nutshell, my absence was caused initially by the rush to get things ready and get here (it was all very last minute). But since I reached here just over a month ago, I have been completely overwhelmed by the workload, not because its too much, but because it needs the ability to focus for extended periods of time.

As things stand, I am in the process of learning.. I'm up to 25 minutes now and it looks as if the path from here on is easier... What this also means is that I will be able to write again

And that's something to look forward to.

PS: I discovered why everyone talks about the weather in the UK... Its the only way to cope with it!

Wednesday, August 18, 2010

More links for August 18, 2010


Ben Bernanke: Wall Street's Servant – Dean Baker, Huffington Post

A ‘Fat Cat’ Strikes Back – Newsweek: For someone who benefitted from a lower-than-lax regulatory environment under Republican rule, its not surprising that Steve Schwarzman has declared war on Obama.

Mel Brooks and the bankers – VoxEU: Its not funny.

Central Bank Autonomy: the real reasons – Mark Thoma, Fiscal Times

Capitalist Myopia – Maxine Udall: Is there any way of avoiding it?

US National Universities Rankings – US News: For those of you who like to know.

A history of how we have fallen

Barry Ritholtz attributes the above to the industrial revolution. I attribute it to our inborn resistance to change. Coupled with high tolerance, its a killer…

Is the RBI just another regulator?

Following Dr. Subbarao’s speech which strove to position the RBI as the only choice for a coordinating regulator, comes this speech from Rakesh Mohan, a former Deputy Governor. Another memorial lecture was hijacked by a blatantly political agenda, and yet the case for RBI’s primacy amongst financial regulators was strengthened only marginally.

Most central bankers, past & present, would agree with the two speeches, not only because they believe it in the underlying cause, but because their approach has been blinkered by their past. They believe that banks are special but the financial crisis of 2008 proved them wrong. Shadow banks emerged as the lead protagonists in the financial crisis of 2008 and central banks couldn’t do anything about it till it was too late. Whether central banks chose to look the other way or were completely ignorant of emerging risks is irrelevant. All that matters is that non-banks could contribute to financial instability in equal measure as banks.

Lest you get me wrong, I agree that the monetary authority should be the coordinating regulator. But that the monetary authority should also be responsible for regulating a segment of the market is another matter altogether. In doing so, the monetary-regulatory body that emerges is powerful but with little responsibility and ownership of other market segments, prone to respond to demands of the segment they regulate even at the expense of other segments. Also, since this entity has very little control over other market segments, its prone to ignore developments that threaten market stability in these segments. Our current system looks more like the US system, with a central bank responsible for monetary policy and bank regulation and an independent regulator (in our case, multiple independent regulators) for the securities market. And this is the very system that failed. But is giving the RBI an exalted position a solution? Not if we are serious about reform.

Rakesh Mohan uses the UK as an example, saying that their move to fold the FSA back into the Bank of England argues for RBI supremacy. Well, it doesn’t. What it does argue for is unification of all agencies under the monetary authority where a homogeneous regulatory framework treats all market segments with equal respect and seriousness. It makes the case for treating banks as just another market segment, and not a market segment deserving special treatment. On the other hand, if the RBI becomes the coordinating regulator, as these gentlemen desire, it grants the bank regulator an exalted status when compared to other regulators. This will only result in more mayhem rather than less.

For a unified regulatory environment to work, it is essential that all regulations be accorded equal importance. Only then will it be possible for the regulator(s) to be in a position to recognize risks, no matter which segment of the financial sector they arise. And for that the RBI, in its current form, cannot survive. For the RBI Governor to be accepted as the head of a unified regulatory framework, this position needs to transform into one which carries direct responsibility only for the conduct of monetary policy. With bank regulation delegated to a Dy. Governor, it will be possible to merge other financial regulators with the RBI with the Chairperson/Head of these regulators as Dy. Governors. But this is just one way and experience indicates that it may not be the right one.

The RBI has always been an excellent regulator. But as I have mentioned earlier, its conduct of monetary policy has been disastrous. It has worked hard to hide its monetary policy failures behind its regulatory successes. And its done so very well. But if one were to look at normal parameters for measuring the efficacy of monetary policy, like inflation, growth & domestic stability, the RBI has failed at every step. This experience suggests that the RBI would be better positioned as a bank regulator, surrendering its monetary policy and financial stability roles to an organization formed expressly for this purpose. This entity will also oversee the functioning of all financial regulators, including RBI.

However, the Committee proposed by the The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF] is not a complete solution. Its brief is to settle inter-regulatory disputes, some of which have held back critical developments in the Indian financial markets and that can only be good. But it cannot ensure financial stability. For that, more meaningful reform is needed.

Reform which does not insist on maintaining status quo at the RBI.