Friday, June 11, 2010

The Great Economic Experiment

For a while I was convinced that Fidesz's action plan is just the result of confusion and lack of time, that's the reason behind its incoherence. However, probably it is a more refined action to achieve the elbow room they wanted. As one of their basic slogans in the campaign was the end of "traditional economics" they decided to prove how problematic its basic assumptions are. This is an experiment, an empirical test of the Ricardian equvivalence, or at least one of its underlying basic assumptions, that rational actors always presuppose later developments and act accordingly. (In its basic form if the government finances today's debt with borrowing taxpayers will expect tax hikes later and therefore they begin to save instead of spending. However, in a generalized form it suggests that rational actors act not only according immediate advantages and benefits but they consider costs occurring on a longer time-horizon.)

What did the Hungarian government in the last few days? They announced an incoherent package of measures with the aim to keep deficit at 3,8% of GDP and simultaneously boost growth through competitiveness. One that probably won't help to keep deficit under control with measures (see my previous post) and contains measures controversial in itself, like the introduction of flat-tax with countermeasures defending lower income categories from losing form their net income due to higher effective tax rates. One very definite countermeasure was the announcement of higher minimal wages. (According to rough calculations the necessary raise would be around 23% plus at about 4% in higher social contributions after the new gross wage.)

What happened after the government made this plan public? The package as a whole was praised by analysts in Hungary while received with more doubt outside the country. (It is worth to note that one cannot easily imagine more rational actors in economics than financial analysts.) The former category can expect a significant material advantage from the new tax system as they certainly belong to higher income categories, the latter are not affected as they are paid under a different tax regime. Up to this moment no financial analyst exposed the controversial nature of the tax "reform", especially regarding its effects on competitiveness. Neither was doubt raised regarding financiability of the tax cuts, even though the offsetting measures are vague and in their present form unrealistic. Nothing was heard from the associations of entrepreneurs, whose companies will be subjected to these changes. (And entrepreneurs should be rational actors, by virtue of being entrepreneurs.)

However, what we are looking at is contradicting to Ricardian equivalence and its basic underlying assumptions. Although it is probable that competitiveness will be suppressed by the higher wages leading to a result contrary to the will of everyone (and certainly affecting companies' profits), the hole in the budget will be filled with tax hikes affecting income later, people for whom the new tax system will bring immediate benefits support it, despite the prospect of negative measures later. They are not acting according to the Ricardian equivalence.

I think the whole action plan is an empirical test of economics. If the government can expose analysts and entrepreneurs neglecting the basics of rational expectations they can claim that the "traditional" economics really failed and ask for their well deserved higher deficit target. Why bother with the reaction of "rational markets" when they are proven to be irrational?

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