Confirmed: Raising tariffs is shooting yourself in the foot

As everybody knows from Econ 101, protective tariffs are harmful for the country that imposes them. A protective tariff is a tax on imports that is so high as to make all imports fall to zero.

But there is an argument why a low tariff may be better than no tariff at all. The reason is that a large country (large compared to its trading partners) faces an upward-sloping supply curve for its imports such that a fall in import demand lowers the world-market price of imported goods. Hence, part of the cost of the increased tariff would fall on the rest of the world due to lower export prices (a fall in the terms of trade) while the country that imposed the tariff might win overall.

Whatever the theoretical merits and demerits of this argument, recent experience with tariff increases in the US (aka Trump’s Trade War) provides powerful evidence against it.

In a newly released paper, Amiti, Redding and Weinstein show that the tariffs imposed last year by the Trump administration had two main effects:

1) US prices of imported goods rose one-for-one with increases in tariff rates.

2) Import demand decreased substantially with an estimated price elasticity of 6 (i.e. 6 percent lower imports for every 1 percent of higher tariffs).

As a consequence of these two results the paper estimates the welfare costs of the Trade War to be about 6.9 billion dollars. While that is not a huge number compared to the total size of the US economy, keep in mind that we’re only talking about a marginal change of the average tariffs from 1.5 to about 3.25 percent. And remember that the welfare costs rise with the square of the applied tariff rate. So should tariffs go up more in the future, the welfare costs will be much bigger.

I regard this as decisive evidence that the optimum tariff is indeed zero. Note that finding No. 1 implies that American consumers are paying the full cost of the tariff increase, with no terms-of-trade effect on the rest of the world. If even the largest economy in the world cannot improve their terms of trade by increasing tariffs, then smaller economies have no hope of doing so either. Raising tariffs is indeed shooting yourself in the foot.

Moreover, this paper is also a triumph for simple textbook economics. The results of Trump’s tariffs are exactly what one would expect from the kind of supply-and-demand model taught in Econ 101. As Tyler Cowen points out, the complete pass-through of tariffs to consumer prices also implies that monopoly power is not a big issue in these markets. It’s good to know that the much-maligned perfect competition partial equilibrium models still gets some important things right.

Intro to Econ: Fifth Lecture – Student Accommodation

Many university towns have problems with affordable student accommodation. In Graz things are not too bad, I think, but I guess things could also be better. Let me make the following policy proposal and let’s discuss whether we think this is a good idea. I suggest a law that states that students who rent an apartment or a room are not allowed to be charged more than €2 per square meter. At the moment gross rent prices in Graz are probably around €10 per square meter (if not more). Do you think this policy would have the desired effect?

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Heinz D. Kurz erhält den Kurt-Rothschild-Preis!

Wie wir soeben erfahren haben wird Prof. Heinz D. Kurz den Kurt-Rotschild-Preis 2018 erhalten. Mit diesem Preis zeichnen das Karl-Renner-Institut und der SPÖ-Parlaments-Klub besondere Verdienste im Bereich Wirtschaftspublizistik aus. In den letzten Jahren ging der Preis an Marcel Fratzscher (Deutsches Institut für Wirtschaftsforschung) und Peter Bofinger (Universität Würzburg).

Als Professor an unserer Universität hat Heinz D. Kurz Generationen von Studierenden begleitet und geprägt. Der Economics Club Graz ist stolz ihn als Mitglied führen zu dürfen. Seine aufschlussreichen und oft humorvollen Ausführungen zu den verschiedensten Theorien großer Ökonomen sind legendär – mein persönlicher Favorit: das Wildlachs-Zuchtlachs-Modell aus der Theory of Production.

Wir gratulieren herzlich!

 

What is economics? A survey

When people ask me what I do, I tell them that I am economist and that my research is about the eurozone crisis, which is enough to satisfy most but not all my conversation partners. Many people want to know exactly what economics is and why it is important. This happens frequently enough that I have prepared a standard response and saved it in my head. But I often wonder how other people respond to the same question.

Therefore I decided to set up a small survey consisting of only 3 questions:

  1. What is economics?
  2. What is economics good for?
  3. What is the most important insight economics has to offer?

You can answer these questions in short or long form, anonymously or with your name. I’d like to get as many different perspectives as possible, so I would encourage you to share this post and/or the survey link below on your social media pages. Warning: I may quote your response in a future post and I may steal it if it’s better than mine.

https://freeonlinesurveys.com/s/XtU7oo9d

Looking forward to reading your answers!

Luis de Molina on the Quantity Theory of Money

I always thought the Quantity Theory of Money was a discovery of the 18th century Enlightenment, one of the first intellectual achievements of the new science of political economy.

However, I recently stumbled across a “Treatise on Money“ by the 16th century Jesuit theologian Luis de Molina which contains, among other economic ideas, a concise statement of the quantity theory as well as some empirical evidence for it.

Molina is best known for coming up with a clever solution to the theological problem of reconciling the omniscience of God with the free will of humans: God, Molina reasoned, knows exactly how humans would behave in any given hypothetical situation (this kind of knowledge Molina called scientia media, „middle knowledge“). In other words, God is the perfect economist: He has complete knowledge of all His creatures’ preferences, their beliefs and their cognitive biases, and therefore can predict what choices they will make freely when faced with any possible budget constraint. This idea helps solving a number of important theological problems, like the issue of predestination or the theodicy.

Anyway, Molina was not only a great theologian, but also a superb economist. For instance, he clearly understood the logic of supply and demand in determining market prices and also saw the logic of no-arbitrage conditions. And here is his explanation of differing price levels in different places:

There is another way that money may have more value in one place than in another: namely, when it is more abundant. In equal circumstances, the more abundant money is in one place so much less is its value to buy things with, or to acquire things that are not money. Just as the abundance of merchandise reduces their price when the amount of money and quantity of merchants remains invariable, so too the abundance of money makes prices rise when the amount of merchandise and number of merchants remain invariable, to the point where the same money loses purchasing power.

And here is his evidence for the theory:

So we see that, in the present day, money is worth in the Spanish territories much less than what it was worth eighty years ago, due to the abundance of it. What was bought before for two today is bought for five, or for six, or maybe for more. In the same proportion has the price of salaries risen, as well as dowries and the value of real estate, revenues, benefices, and all other things. That is exactly why we see that money is worth much less in the New World, especially in Peru, than in the Spanish territories, due to the abundance there is of it. And wherever money is less abundant than in the Spanish territories, it is worth more. Neither is it worth the same in all parts because of this reason, yet it varies according to its abundance and all other circumstances. And this value does not remain unaltered as if it were indivisible, yet fluctuates within the limits defined by the people’s estimation, the same as happens with merchandise not appraised by law. This money’s value is not the same in all parts of the Spanish territories, but different, as ordinarily it is worth less in Seville—where the ships from the New World arrive, and where for that reason there is usually abundance of it—than what it is worth in other places of the same Spanish territories.

Modern macro was invented by a Soviet economist

Here’s the story.

In 1927, a Russian economist by the name of Eugen Slutsky wrote a paper entitled “The Summation of Random Causes as the Source of Cyclic Processes“. At the time Slutsky was working for the Institute of Conjuncture in Moskow. That institute was headed by a man called Nikolai Kondratiev.

This was in the early days of the Soviet Union, before Stalin managed to turn it into a totalitarian hellhole, a time when the Communist leadership was relatively tolerant towards scientists and even occasionally listened to their advice. The institute’s job was basically to collect and analyze statistics on the Russian economy in order to help the Party with their central planning. But Kondratiev seemed to take the view that it would be best to allow the market to work, at least in the agricultural sector, and use the proceeds from agricultural exports to pay for industrialization. Lenin apparently took the advice and in 1922 launched the so-called New Economic Policy which allowed private property and markets for land and agricultural goods and re-privatized some industries which had been nationalized after the October Revolution. This policy turned out to be rather successful – at least it ended the mass starvation which War Communism had caused during the years of the Russian civil war.

But then Lenin died and Stalin took over and decided that time had come to get serious about socialism again and finally abolish private property and markets for good. Dissenting voices like Kondratiev’s clearly couldn’t be tolerated in this great enterprise, so in 1928 Kondratiev was sacked and the institute was closed down. Some time later, Kondratiev was arrested, found guilty of being a „kulak professor“ and sent off to a labor camp. Even there he continued to do research until Stalin had him killed by firing squad during the Great Purge of 1938.

But I’m digressing, so back to Slutsky. His 1927 paper was written in the wake of Kondratiev’s 1925 book “The Major Economic Cycles“. That book claimed that capitalist economies exhibit regular boom-bust waves of about 50 years duration, known today as Kondratiev Waves. Other „conjuncture” researchers had claimed the existence of shorter waves.

Slutsky’s first observation was that when you really look at time series of aggregate economic output, you don’t see regular waves, but a lot of irregular fluctuations. So trying to find deterministic, sinusoidal waves in economic time series is probably not a very fruitful exercise.

Slutsky’s second observation was that when you draw a long series of independently and identically distributed random variables (modern terminology, not his) and then take some moving average of them… you get a time series that looks an awful lot like real-world business cycles!

He showed that in two ways. First, he performed simulations. Remember this is 1927 – so how did he simulate his random numbers? Well, the People’s Commissariat of Finance ran a lottery. So Slutsky took the last digits of the numbers drawn in the lottery (this is the basic series shown in figure 1). He then computed a bunch of different moving average schemes one of which is shown in figure 2. See the boom-bust cycles in that picture? Pretty cool, huh?

slutsky_waves.001

 

But Slutsky didn’t just show cool graphs. He also had a beautiful argument for why these moving averages looked like recurrent waves:

We shall first observe a series of independent values of a random variable. If, for sake of simplicity, we assume that the distribution of probabilities does not change, then, for the entire series, there will exist a certain horizontal level such that the probabilities of obtaining a value either above or below it would be equal. The probability that a value which has just passed from the positive deviation region to the negative, will remain below at the subsequent trial is 1/2; the probability that it will remain below two times in succession is 1/4; three times 1/8; ans so on. Thus the probability that the values will remain for a long time above the level or below the level is quite negligible. It is, therefore, practically certain that, for a somewhat long series, the values will pass many times from the positive deviations to the negative and vice versa.

(For the mathematically minded, there’s also a formal proof just in case you’re wondering.)

Since it was written in Russian, the paper went unnoticed by economists in the West until it came to the attention of Henry Schultz, professor at the University of Chicago and one of the founders of the Econometric Society. He had the paper translated and published in Econometrica in 1937.

And so Slutsky’s „random causes“ provided the first stepping stone for the modern business cycle theories which explain how random shocks produce, via the intertemporal choices of households, firms and government agencies, the cyclical patterns we see in aggregate time series.

P.S.: All this time you have probably asked yourself: Slutsky, Slutsky,… that name rings a bell. Oh right, the Slutsky Equation! Yep. Same guy.

“Self-financing” tax reforms: a simple formula

There is much talk these days about tax reforms, both in Austria and around world. Most political parties seem to agree that taxes on labor are too high and that cuts should be made. There is disagreement as to whether these tax cuts should be accompanied by cuts in government spending or increases in other taxes.

One recurrent issue in this debate is the extent to which tax cuts are “self-financing”. This usually comes from a vague notion that reducing tax rates has a “stimulating” effect on “growth” and “job creation”. Such “stimulus” makes the tax revenue increase thus offsetting some of the revenue loss due to the reduction in tax rates.

Although I usually take great pleasure in brutally debunking popular myths with my profound knowledge of Economic Science (insert resounding laughter here), let me say that I think that in this matter the vague notion of the layman is broadly correct.

Economics being a hard quantitative science, the careful economist always strives to replace broadly correct but vague notions with mathematically exact but only vaguely correct formulas. In this spirit, I offer a formula for calculating to which degree a cut in the marginal labor tax rate is “self-refinancing”.

We start from a definition: total tax revenue (T) is the tax rate (t) times income (Y):

 \displaystyle T = t\times Y. 

We treat t as both the average and marginal tax rate. In fancy language: income taxes are assumed to be linear. Not true, but (one hopes) true enough.

We want to know how T changes if t is reduced by a small amount dt. There are two effects, one direct, one indirect. The direct effect is to reduce T by an amount  \displaystyle Y dt . The indirect effect comes from realizing that Y depends on labor input L which, in turn, depends on the tax rate. So therefore, if we reduce the tax rate by dt, labor supply rises by  \displaystyle n dt , where n is the elasticity of labor supply. The increase in labor input raises output and thus income. Suppose the elasticity of output with respect to labor input is a. Then the total change in income is:  \displaystyle dY = (\alpha\times n)dt. 

The indirect effect is where “self-financing” comes from. Let us measure the self-refinancing effect of the tax cut by  \displaystyle X = t\times dY/Y, which is the indirect change in revenue measured in percent of income.

 \displaystyle X = (t\times\alpha\times n)dt.  *

The self-financing share X is larger, the higher the initial tax rate, and the higher the two elasticities  \displaystyle \alpha and n.

How big is  \displaystyle \alpha ? Well, consider a Cobb-Douglas production function  \displaystyle Y=K^{1-\alpha}\times L^{\alpha} , where K stands for other factors of production which we hold fixed for purposes of this exercise. The labor elasticity of output is  \displaystyle \alpha. It is well-known that under competitive conditions a is equal to the labor share of income. In Austria, as well as in most developed countries, this share is about 2/3. So let’s take that as our answer.

How big is n? That’s a tough one to measure. Theoretically, it depends on the labor-leisure preferences of households as well as on other „deep” parameters of the economy. The empirical evidence I have seen suggests that a 1 percent decrease in t increases L by less than 1, but more than 1/3 of a percent. Let’s take 1/2 as a guess.

Finally, what is t? In Austria the marginal income tax rate is close to 50%, the average rate is in the area of 30%.

Feeding these numbers to our formula we arrive at the following conclusion. The self-financing share of a tax cut is in the range between 10 and 17 percent. This means that a tax cut of 1 billion euros indirectly creates additional revenues between 100 and 170 million euros. That still leaves a hole in the public budget of at least 830 million euros, though.

*) The General Formula is:

 \displaystyle dT = Ydt + t\times\frac{dY}{dL}\frac{L}{Y}\times\frac{dL}{L}\frac{1}{dt}\times Y dt