Mark Pittaway, 1971-2010. R.I.P.

Just a short note on an official website, but an enormous loss. Banalities rush to my mind, maybe one of them is decent enough to dedicate it to the memory of a friend.: the most tragic of losses when you must realize the one who passed was so much better than you.

Update: The Open University website has now a tribute page.

Hungary and sovereign default

It's almost official: the government's ingenious plan is to nationalize compulsory private pension savings and spend it on current budget expenses (pensions) and debt reduction. They hope it will enable them to survive without major restructuring and action until the tax cuts will bring 7% GDP growth. (Actually many expressed doubts, how realistic this expectation could be. Some calculate that 8-10% growth would only fill the holes of the budget from 2013.) Anyhow, the government expects 90% of the mambers of such private pension schemes will return to the state run, pay-as-you-go system, eventrually transferring their portfolio to the state. The delicacy of the issue: it is nothing else than default on a part of the debt and restructuring.

Private pensions savings, although compulsory, are private property. They hold about 2800 billion HUF savings in sovereign bonds (circa 1300 billion) and other assets, mainly stocks and investment funds. It means at around 5% of the GDP is in the hands of these private as government issued bonds. As soon as they transfer it to the government they will be rewarded with a promise of a state pension and their portfolio transformed into state property. Obviously the state will never be obliged to redeem them, it will reduce the debt. It is not a straightforward way of default and debt restructuring, but in its essence it is nothing else. Government liabilities at private debtors are declared void and exchanged to another type of government liablity. At the moment it is - nominally - voluntary. However, the pirme minsiter expressed his firm conviction that as much as 90% ot the members of private pensions schemes will choose the satte run system in two months time. As this number is highly unrealistic on a voluntary basis one could expect legislation making it compulsory, transforming the process in a confiscation. Especially in the light of Fidesz's willingness to reduce the jurisdiction and competenc eof the Constitutional Court, barring it from judging the constitutionality of economic legislation.

Hungary in fact defaulted today...

White mice - Updated

After months of permanent "revolution" the prime minister, Viktor Orbán announced new measures this Wednesday aimed to bring the budget deficit under the ceiling aggreed with the EU, supposedly without austerity. It would be easy to mock him how he defines austerity (as next years budget is planned with a nominal cut in budget expenditures, obviously affecting a lot of people) but I presume it will be a popular activity in the coming weeks. It is more interesting whether this new action plan (complemeted with a modified tax system due to be announced next Monday, but a series of ideas already known) signals a dicision at last concerning the economic policy. Especially as the 29 point from June were the sign of indecision. (See my post here.)

It would be easy to dismiss yesterday's plans as the postponement of this state of agony, as it is not easy to see any coherent direction of action in the rather patchy series of new - intentionally only temporary - levies. However, considering the nature and content of the earlier internal conflict and the resulting political dilemma for Orbán, this time one should assume the decision has been made and what one can see is the backbone of the new economic strategy of Hungary's government. For years economists around and inside Fidesz fought a pitched battle whether the state has to be reduced with drastic cuts in order to make room for tax cuts in a corresponding extent or taxes should be reduced without any offsetting measures. Funnily and ironically proponents of both directions pointed out the same examples, most notably Slovakia, but in the last few years Romania and Bulgaria as well. The representatives of the former line - many of whom participated in the activity of the Reform Alliance in 2008 and 2009 - argued that the size of the state was and is too large and its extent of income redistribution - especailly with its ratio of social expenditures - is crowding out private investment and depresses initiatives. A much smaller state would enable the private sector to invest more leading to higher production and with time higher income. However, according to this line of thought, the balanced budget is a precondition of higher grwoth, because the budget deficit is just as harmful as the high redistribution ratio. If the state runs deficit it needs financing and the sivereign bonds issued attract the capital easier than investment. Those holding an opposite view in Fidesz do not deny the necessity of a smaller state. Nevertheless, their recipe is quite different, as their diagonisis focuses on the reasons of the weakness of economic growth eslwhere, finding it in the lack of sufficient internal demand. Therefore they propose a kind of shock, government measures in order to raise personal income levels creating the preconditions of rapid growth.* They presume this boost of internal demand would lead to such a growth rate that would allow a larger state expenditure in nominal and real terms and simultaneously reduce the redistribution rate as a ratio of GDP.

It is clear the latter "soultion" needs either a very benevolent attitude form those financing the diefict or a permission of the EU, the guradian of the Stability and Growth Pact, because it is usually seen as a way leading to immediate worsening of the situation of the budget. Even if faster growth would bring higher revenues with time as the proponents of this solution claim (far from being certain, but a very popular argument) someone has to finance this transitional period. The idea of a higher deficit for this year, so ferociously defended (portrayed as inevitable) during the run up to the election and afterwards served exactly this purpose. After the EU Commission reppoached Orbán and made it clear they wouldn't accept any deviation from the plans outlined by the outgoing government the circle looking for this way needed to find another soultion. For a while it seemed the former group prevailed and next years' budget will be constructed very cautiously, but meanwhile there were signs of attepmts signaling the almost desperate will for implementing the second version of economic policy. Despite these signs "analysts" and "economists" were deluded by the readily repeated promises of government officials that Hungary will stick to the deficit target both this and next year. They convinced themselves it logically means bugdet cuts, asuterity, reforms.**

Yesterday it turned out we won't see the first alternative being realized, instead Orbán Viktor opted for raising internal demand without lasting measures to offset losses. It doesn't mean the budget won't be extremely tight, but every inch of room for maneuvre will serve the purpose of a huge tax cut. (The one I sketchily characterized in my previous post.) However, the whole action has a transitory nature as the government expects a new wave of additional revenues from higher growth. New windfall taxes on telecommunication companies, on the energy sector and on retail cahins will be imposed (already due this year!) and contributions to private pesnions schemes (obligatory for at about 3 million people in Hungary) will be withhold in the budget. Whether it is the first step towards complete nationalization (a very contorversial issue under EU law) or just a necessary step to cover losses temporarily (the minister hinted to an eventual compensation, although without specifying its nature) is not clear. Anyway,for many observers it seems the government bought itself enough time to bring about its tax cut without destroying the budget and placing the country at the mercy of external financers. Doubts are only raised regarding durability of the reduction of the budget deficit when these measures expire without significant reforms.

If the informations regarding the harsh cuts in the budget (affecting sectors like health care, already drained by years of austerity) turn out to be correct one should conclude the situation is more serious than one would have thought earlier. In this case it will be clear the country is the scene of a mass experiment of supply side economics and the government is playing a gamble. Not that some of the problems they conceive would not be real. Further austerity - albeit propsed by the EU and requested and expected by the markets - could easily push Hungary to the Greek, Irish or Portuguese road. Austerity depresses growth and fails to reduce debt to GDP ratio lastingly making a new wave of cuts necessary and further depressing growth. The vicious circle is not easy to escape (I tend to think it is impossible without coordinated efforts of the EU) and the governments plans to brake it can be seen as legitimate. Although some of the doubts echoed are equally legitimate, the real problem with the proposed solution lies elsewhere. The government relies on the assumption that the only hindrance for growth in the country is the depressed internal demand and a sufficiently strong boost will give the necessary impulse to the economy, bringing new orders to local SMEs etc. In order to achieve this they will introduce a Slovak-type tax system (they even copied the abolishment of the inheritance tax) accompanied by Slovak-type social assistance system, but contrary to the Slovak model they won't prefer market-oriented reforms of systems like the health care, child benefits or pensions. A very strange version of neoliberalism (provincial and protectionist) but still supply sider neoliberalism.

This is exactly the Achiles heel of the whole plan, it focuses on one single factor and assumes a large enough change will generate substantial changes in the whole economy and society. Ironically, it would need a completely and perfectly funcitiong economy, something doesn't exist in the country to the extent the plan would presume (and the existence of which would make the whole idea obsolete). But beyond rather insignificant general observations the whole plan suffers from many important deficiencies. Firstly, there is no sign of the rowth generating effect of stronger internal demand among the present circumstances. Real wages and incomes have grwon in Hungary in this year due to not insignificant tax cuts for middle income categories. On some income levels it was almost 10% raise of net income and on an aggregate level in the first half of the year real income was 5% higher than a year earlier. (This is now fading due to base effects.) Nevertheless, retal sale were continously decreasing, an omnious sign for every attempt to use internal demand as a means of stimulus.***

An even more important factor giving way to doubts is the very uneven distribution of benefits from the proposed tax cuts either in terms of social status or georgraphy. According to preliminary calculations based on the leaked informations on the new tax system a very sognificant part of the working populatioin will not be better off or only with an insignificant ammount, probably meaning a loss of real income. It won't be offset by the child allowance fr these social groups. Moreover, even families with low income but three or more children will not benefit from the generous child allowance. The only group that will certainly enjoy a significant advance in financial terms will be the one of families with high income and three or more children, while the more people earn at the present the more positive the effects of the tax cut will be. Although it is hard to assess the distribution of the tax cuts precisely, it is safe to assume it will make better the position of those with a lower marginal propensity to consume except families with children. Moreover, while the tax cuts can serve as a stimulus via internal demand, the cuts of budget expenditure will have a negative effect on public invesment and public consumption, a factor of GDP dragging down growth already for years. Once again, I have no clue to the ratio of these conflicting effects, but it is hard to accept the planned 500-600 billion HUf tax cuts will raise grwoth with the envisaged 2%.

Of course one can say at least the demographic effect will be positive and I wouldn't be surprised to learn of a temporary positive change in the birth rate in next year. Given the number of live births just under 100000 per year 10000 additional newborn would be a very significant development. However, as I mentioned the child allowance will only mean a significant help for thosew with extremely high income (by Hungarian standards) and with three or more children. People with high income could opt for a third child, but it still won't change the picture fundamentally. Meanwhile the sate will renounce on the social infrastructure of child upbringing (kindergartens, play-scholls etc.) as it won't have the necessary funds to rebuild the instiutions lost in the last two decades. The well-to-do large families will be able to afford private kindergarten (the monthly fee of which is equal to the ammount of the entire child allowance planned!) and will be able to finance one of the parents remaining at home, while those with less children and/or lower income will still struggle to reconcile work (substantial to secure an accepatble family income) and child care. The whole complex is aggravated by the fact that in the backward regions of the country where unemployment - longterm, structural - is concentrated and where the above mentioned larger family type with low income (somteimes living on social assitance) is widespread people's burden won't really be lifted by this new tay system. The result: higher inequalities in the country, less opportunity for people in these reagions and less social mobility. The latter is especially important as under the planned tay system lasting positive developments in demography would need very strong social mobility, because the real positive effect on birth steps in at higher income levels. As long as one can not break away from poverty or the trap of mediocre income one could not really enjoy generous child allowance. (The difference is huge. The child allowance is worth 10000 HUF for the first two children each, and 33000 for each children after the third one is born!)

(Some additional thoughts.) The last - but not the slightest of problems - of the new line of action is that ironically it makes Hungary even more dependent on external factors than earlier. While the government claims to have realized economic independence with getting rid of the IMF, its plan is based on the positive development of a series of external factors. Even if one assumes a turnaround in the reatil sales (a signal of grwoing internal demand) public consumption and investment will affect GDP negatively. Therefore, Hungary will need significant export growth to make its very ambitious plans a reality and collect the revenues envisioned. However, the tax cuts has almost no effect on competitiveness and there are some ominous signs. In the first half of this year the extraordinary growth in germany did not generate enough export oriented economic activity to have offset the decrease elsewhere. If the world ecopnomy will slow down Hungary can find itself trapped again. Beyond this worrying possibility one should take into account the ongoing sovereign debt crisis in the eurozone. If in March, when Ireland will return to the financial markets its yields will still be too high to lend credibility to its claim of beginning to reduce debt as a ratio of GDP the whole edifice can collapse, bringing down Hungary as well. Meanwhile the world economy is inchoing towrads "currency war", a series of competitive devaluation, a dangerous development to the export capabilities of the EU.

As it seems although Hungary freed itself from the the IMF (but not from rules of the EU, that are much less flexible) it did not gain a larger influence on these exterenal factors. While countries had a chance to really negotiate measures with the IMF, and that way implement an economic policy - at least partially - of their own making and enjoying the safety of having the support of this institution, now the Hungarian government acts in the hope that every single external factor it can not influence will at the end contribute positively to its economic plicy. In this sense Hungary is less and not more independent at the moment, its future hinges exclusively on the positive developments in the world.

I do not want to presage an inevitable failure of this new policy, although I have not much confidence in it. But even if I try to make this generous gesture of fair play I could not escape feeling myself as a white mouse looking out of a cage juts before entering a labyrinth in a new laboratory experiment.

* Please note, the owner of this blog doesn't concur with any of these opinions, considering them very simplistic if applied to Hungary's present state of affairs and in general as well.

** One should pay respect to the few exceptions, most notably among the Peter Attard Montaldo at Nomura, who echoed suspicion from the beginning.

*** There could be many reasons for this surprising development. One of them is certainly the process of deleveraging, especially as the fx-based loans were hit by the rapid deterioration of the exchange rate of the HUF against CHF and EUR. People probably pay higher mortgage rates from their higher income, something that could easily last for years.

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?

An action plan of indecision? Updated

Hungary's new prime minister, Viktor Orbán announced yesterday his "action plan" a set of measures seen as the guidelines of the government's economic policy. The announcement followed days of insecurity caused by remarks of Fidesz and government officials on the budget deficit this year, frequently using phrases "like Greece", "default" etc. This debacle (retrospectively Fidesz politicians - speaking only from behind the defense line of anonimity - hinted to a conscious strategy, but the party has a tendency to reinterpret every failure afterwards into a plan of a mastermind, therefore it is less and less credible with time) signaled the abandonment of earlier ideas and the realignment of the possible policies.

Anyway, the prime minister delivered a very conscious speech conveying the will and energy to achieve his goals and announcing 29 measures. It had an immediate effect, it was certainly a good show of an illusionist, especially among Hungarian analysts, whose obsession with flat-tax is almost a medical case. Many of them hurried to hail the greatest structural change of the last two decades etc. And the impression in general was certainly favorable, on the surface the new policy seemed to be really well thought. Nevertheless, if scrutinized with a more critical eye - without allowing oneself to be deluded by the flat-tax - it is a surprisingly empty and astonishingly not elaborated package.

The starting point was that the government has to achieve a budget deficit as high as 3,8% of GDP this year, because the IMF and the EU (espacially the latter) would not let them to raise th target to 5-7%. However, Fidesz promised a "tax revolution" in the campaign (although it was clear that they couldn't decide whether to opt for flat-tax or a family-tax system, copying the French model) and tax cuts for enterprises. After they lost a lot of room for manoeuvre when they had to accept the lower deficit figures they still stuck to this idea and decided to find other sources of revenues to offset the income losses. The solution was imaginative but not quite convincing: the banks will pay a half of their profit to the budget in order to allow them to relax the tax burden on individuals and on other companies. Besides the 16% falt tax combined with the family tax the prime minister announced the reduction of the wage costs in the public sector, reduction of tax on companies' profit (at least for those who has a profit less than 500 million HUF) from 19% to 10%, complete freedom of distilling spirits for individuals (really!) a freeze of public services fees for the population, a ban on mortgage based fx-loans and some symbolic measures, for example reducing costs in the state sector and subventions to political parties.

However coherent it seems (and the underlying idea, even if its is horrific, is really coherent) it do not need a Nobel-prize winner to discover how scratchy it is nd how much it lacks the essence of political action: decision on some core issues and acceptance of confrontation. First of all it is still not a decision to fuse two tax systems based on very different principles, it is the opposite: an escape from decision. Considering this state of affairs it is not quite surprising that today none ion the government was capable to give information on details. There will be something with a 16% flat tax rate and with tax breaks and credits for families raising children, but to wich amount the latter will extend, what will happen with the so-called "szuperbruttó" in the present system ("super-gross calculation" an effective extension of the tax base, it taxes the ammount of the social contribution as if they would be part of the income itself) and the tax rebate. Even more serious issue is the problem of "lower wages". The present system - due to a very extended tax rebate - lays only 16% tax on a monthly income of 230000 Huf well over average and median wage in Hungary. The elimination of this part of the system was announced - in two years - which at first sight will effectively mean a tax hike for everyone with 230000 Huf or lower income. There were hints that the government will ensure that no one pay more, but there seem to be no other solution than to raise wages, but an effective 20% wage raise will not deliver one if the most sacred result of as flat tax system (at least in the eyes of its adherents): lower labour costs. (On the idea that it will create incentives to present previously untaxed incomes for the tax authority you can see my earlier post. The very theory used to support the flat tax contradicts to this idea. There is no evidence, ECE countries with flat tax are more infected with black and grey economic activity than Hungary, according to every estimate.)

Similarly vague is the idea of the reduction of costs of public services. It is even not clear whether this applies to the entire public sector, only to certain parts of it or to the state owned companies? While the prime minister mentioned 120 billion Huf as saving for this year and referred to it as 15% reduction of these costs, the only concrete measure was a 48 billion reduction at state owned companies. (But it is tricky as it is the 15% of the wage bill for the entire year while the cuts will come in the second half. The result: 25-30% for six months!) Whether public instiutions, ministries, authorities or schools, the health care sector etc. will bore the remaining 72 billion or just a part of it it is still not clear.

The freeze on public services prices was declared to be temporary, until the government negotiates something with the respective companies. However, price control will soon be reestablished. The bank tax announced without preliminary consultations. Even the method of "liberating" spirit distillation is not clear., it is at the moment not more then a wish list without calculations. And it is based on a very tight calculation, without any reserves and always counting on the most optimistic scenario. If the bank tax falls of or fails to deliver the necessary amount, if growth will remain sluggish the deficit will soar up and austerity will settle to other sectors. Moreover, even the real extent of tax cuts is not clear, because no one knows the amount of family tax breaks and rebate and the future of the present tax rebates. Therefore no realistic calculation of the effect of the package on the budget is possible. (And no structural reforms - some percentage points relaxation in an already almost flat-tax system is far from being one, across the board cuts in the public sector can also be seen hardly as such,Gyurcsány would have been ridiculed by the same "analysts" with a similar action plan who are now praising Orbán.) We have seen the sorcerer, the white rabbit was fat and juicy but it evaporated in a day....

However, the direction is clear: redistribution of wealth from the lower strata to the rich (the very rich) and from the poorest regions to the richest quarters of Budapest. It's negative effect on local economies is predictable as purchasing power will dissipate (while the positive effects of creating jobs is doubtful at best, the recovery could easily turn out to be fragile with the austerity programs of EU governments, the most far-sighted ideas of the Fidesz program were postponed - investment into energy efficiency, for example - or even thrown off etc.) and already huge differences in the country will grow. Well, the show was excellent, but the road is still covered by thick fog.

Update: So, we have a plan with the aim to keep under control the budget deficit and boost competitiveness through lower labour costs. But the secretary of state in the ministry of national economy responsible for tax issues announced today that the "szuperbruttó" will be eliminated and no one will be worse off in the new system (i.e. no one will have lower net income) than in the old one. No details, of course.

But even in this very basic and vague form the plan seems to be way off the announced aims. If the government will pressure companies to raise wages it will negatively affect labour costs without an equivalent raise in productivity. At the moment the average wage of 56500 physical workers in the agriculture is 109746 HUF. They would need a 12,2% higher wage in order to have the same level of net wage. But it would mean an additional 3,5% in higher social contributions as well. Similarly, the (non-existent) average industrial worker (441900 people) will need a 7% rise in wages what would mean an additional 2% in social contributions. The 195900 workers in the commercial sector will need a 10,7% higher salary, an additional 2,9% burden in social contribution. Moreover, the state employs hundreds of thousands of public sector workers and teachers, nurses etc. who also will have to enjoy the benefit of higher salaries in order to offset negative effects - if the secretary of state mentioned above told the truth. 3,5% raise for average employees in the health care sector (148300 people), 13% for physical workers in the same sector (90200 people), 10% for physical workers in the educational sector etc. Certainly more than 30 billion HUF just in order to compensate them real wages still declining. It is still not a well thought plan, just improvisation.

Rewind?

With the events of the last few weeks one can easily think we are back to the gloomy days of early 2009. Unfortunately Marx’s famous dictum, everything in history is staged twice, once as a tragedy and again as a comedy, proved to be wrong. The tragedy of East-Central Europe was followed by the tragedy of South Eastern Europe: Greece and the unnoticed one, in Romania. The former literally collapsed (even if in an orderly way), one cannot perceive the measures adopted otherwise. The latter were and is on the verge of collapse, with decisions unheard of earlier taken. (25% cut in the wages of the public sector, 15% reduction of the pensions, closing down half of the existing hospitals, new taxes introduced and an overall tax hike is still not excluded.) Unfortunately no one will really revise his/her earlier views of the country as a rapidly emerging one, albeit the social costs of these measures (and coupled with the drying up of financial transfers from abroad, from workers in Spain, Italy etc. the economic ones) will hardly positive. Even if in a sense they were unavoidable.

Meanwhile, there are no signs of a vigorous recovery in the Baltics, where the strategy of internal devaluation – underway in Hungary, began in Romania and Greece - was fully implemented and hailed by some observers. Moreover, the  Estonian economy – seen as the first to emerge after a series of good signs in export – slipped back in the first quarter f 2010, albeit technically not in recession again. This is not spelling too much good for the new patients.

But the real problem is that it is still not certain that the decisions announced by EU politicians last weekend (a new bail-out fund worth between 500 and 750 billion euros) is the last act of the drama. First of all it is worth to remember: Europe stood here once, 14 months ago, when the idea of a 180 billion fund for the ECE countries – floated by then-prime minister Ferenc Gyurcsány was brusquely refused, most energetically by Angela Merkel. (Whose government, due to the problems I outlined in earlier posts suffered an important setback at last Sunday’s provincial elections in Nord-Rhein Westfalen.) It is not sure whether that amount would have been enough, but in a less strained environment, financial actors less focused on sovereign debt issues, it would have had a chance. Now – calculating with her share in the Greek package – Germany alone has to offer this amount.  And no one knows, whether it will suffice or not. Especially if the „markets” wake up from their excitement (driving them on Monday to exaltation) and realize: the offered solution is twofold and not exactly what they would like to see. It includes intensive monetisation of sovereign debt (something abhorring for monetarism, but a widespread practice throughout history) and bringing increased danger of inflation. (Albeit many, among them Paul Krugman, argue that under the present, deflationary circumstances this is not something one should be afraid of.) The other downside of the offered solution is that it is nothing else than issuance of new sovereign debt by countries already seen as heavily ladden with debt. (After the derivatives of the mortgage playing a role in the first phase of the crisis we can see the creation of sovereign debt derivatives – with what effect?)

I fear at the end the world have to accept the plain fact: the bubble has to be deflated and at the losses have to be distributed somehow, not just transferred from private books to state households. It will be painful, in the form of debt restructuring (in an orderly way) and probably through inflation and affecting everyone as a lot of savings and wealth of ordinary people were accumulated in financial vehicles and it will be accompanied by lower present day and possible future living standards. But at the moment the solution of taking over these debts by states seems not working in the long run and eliminating the burden with vigorous growth –while addressing competitiveness issues will need keeping costs( i.e. wages) as low as possible therefore dumping local demand – will eventually pose the question of where to export?

(Inflation is painful and can easily run out of control. But this process was underway for almost a decade, only outside our books. Anyway, the bubble blown on the financial market was the very sign of inflatory pressure, or even the inflation itself. A very dangerous, self-sustaining one, as the rise in share prices (less supported by growth output than by profit) was a form of inflation. Only as long as this mass of money was kept outside the „real world” its existence was not reflected in „real prices”. But why not apply some concept of inflation to financial market as well? Couldn’t it be a model case for inflation?)

 

Anyway, the new wave of crisis arrived, after more than half a year of restful period. Meanwhile the political landscape in Hungary was completely transformed (just as it was predicted on this blog when Gyurcsány resigned, with the painful campaign…) and we will have a chance to see the new government (pompously describing itself as a new regime born from a revolution) dealing with these issues. Hopefully they will be a bit different from their newly found ally in Romania, where the politicians (often implicitly portrayed as the courageous ones, compared to Hungary) postponed hard decisions and now have to announce a package they didn’t want. But they are almost immediately ready to give in to popular pressure….

 

And probably – If the events will speed up – I will return to posting…

On taxation II.

Although in the previous post I mentioned macroeconomic context of taxation as the topic of this follow up post, as a layman I do not want to claim to analyze the issue in depth. My aim is only to pick up some themes  - some frequently mentioned in the public discourse, some totally absent - I find intriguing, nothing more.

The whole problem is centered around the redistributive role and the distortive nature of the taxes in the economy. From this angle taxes serve to channel money (capital) from the economy and from certain parts of society to others. As a discretionary levy on income or capital they nature is to change the incentives of the free market and pulling or pushing the economy out of its natural balance. (However, as some functions of the state are considered as necessary - setting the rules, guarding property rights, carry out judiciary decisions etc. - and their exercising is only plausible with some state revenues to a certain extent this distortion is unavoidable. But the extent is disputable and disputed.)  The first issue to be discussed here is the redistribution, whether it is negative under the present circumstances - i.e. in the crisis and with the necessity of tight fiscal policy narrowing consumption as a driver of economic growth. It is a specific approach, far from claiming universal validity.

An appropriate starting point is the model of the last decade (or in case of the US even the last 25 years) Income and social differences has grown in many Western and ECE countries. In the US it is usually associated with the tax changes, preferring - at least relatively - those in the upper income and wealth categories and in ECE - especially in the last decade - it is a result of the foreign direct investment based growth. (Although the necessity to follow this path and the possibility to find a different growth model is a topic of frequent contradiction, for my post the existence of this model will suffice, and it is not a prejudice regarding the merits of this path.) Nevertheless, as the US economy is based on internal consumption and in the transition countries the long period of subdued consumption led to a widespread desire to acquire the goods neglected during the change. The result - to sum it up simply, thus a bit simplystically - was the growth of credit aimed at consumption as real income growth couldn't serve as the basis of increased consumption. 

But why it is a problem when the growing national income - as in almost every country long and protracted periods of growth characterized the last decade - is not redistributed heavily, thus leading to growing income differences? Leaving aside moral considerations and not claiming that it necessarily fits to every situation one issue was the sustainability of the growth path. It is usually presumed that people with lower income tend to consume more as the ratio of their revenues ad to an extent it is true for additional income as well. This is mainly based on the fact that they usually can not satisfy their needs and desires because they disposable wealth is not enough. To the contrary, those with higher incomes, although spending more nominally, can easily save a higher ration of their income as it is significantly higher than their needs. (It is worth to note that the propensity to consume is influenced by social behavior as well, either on individual level or in societies with higher savings rate the consumption ratio can be relatively low even in lower income categories.) In general higher income of people in lower strata is perceived as a more certain way to drive up consumption, while the opposite is rather advantageous for higher savings. But it also means that if cheap credit is available for everyone, those with relatively low income can afford consumption. However, if one considers sustainability, the latter case is more problematic, as to keep the same growth rate without providing higher incomes means the constant raise of outstanding credit based on the rise of asset values. Conversely, as soon as asset values decline a credit crunch can easily occur. Beyond this "practical" problems it is also a debatable issue whether asset values can rise indefinitely.

A usual counterargument assumes that the economy is a closed system in which revenues are either consumed or saved and saving lead directly to investment increasing production on the long run. Therefore the higher savings rate of upper income categories is not directly affecting growth, as what they save is equally productive as the consumption at the lower stages of the ladder. In a closed system where financial tools are destined to transmit resources from one segment of the society to the other directly it is probably true but, but it is not so easy to determine whether modern savings techniques results in this very straightforward relationship. Moreover, due to the reliance of these savings techniques on the creation of the money in the financial system in order to create profit (it is the very basis of a financial bubble) even the channeling of savings into production is questionable. Not to speak of the difficulties of identifying the destination of such savings in geographical terms. It is probable that savings from Budapest will land in production in Brasil and this uncertainty again reduces the validity of the above mentioned model. The system is far from being closed and the relationship between the sectors are less clear and direct - due to financial innovation and globalization - as it was once. (An important aspect, tackled below is the profitability, whether financial investment brings less, equal or more profit as investment in production.) 

At least two consequences of this state of affairs have an impact on the considerations regarding the desirability of taxes and redistribution as a means to drive consumption. As the need to enhance competitiveness seems to grow instead of decreasing - due to the structural problems export is the favored way to create a current account surplus and cut down debt/to GDP ratio - wages can not be raised significantly (or only net wages through tax cuts, but the limitations of such measures to raise net income was the topic of my previous post) and it will limit the growth of consumption. If this driving force of the economic activity would need to be enhanced - and this is a matter of further consideration - the only feasible way seems to be redistribution as it would channel wealth from sectors of the respective societies where it is even not necessarily plays the role of being the source of investment to sectors where it could serve as a resource of consumption. (However, as the environment is rather inspiring deleveraging, getting rid of existing debts through savings it is far from being certain.) But beyond this - and probably more important - the validity of the model of government outcrowding is less plausible as it is treated in the public discourse. (This model relies on the assumption that private income is either consumed - that way poured into the economy - or saved - and the savings are directed by the financial institutions to the economy as sources of investment. The government's intervention - through collecting taxes - hijacks valuable resources and detours them. Although it is acceptable to a certain extent, if the government removes too much money from the private sector - especially if it happens through deficit spending covered by borrowing. In this case it usually assumed that less risky - and sometimes more profitable government bonds are more attractive to investors than company's bonds or savings accounts. Therefore the government collect and redistributes the money that would otherwise flowing swiftly into the economy. (The extensive taxation  has similar effects, as in this case the government directly expropriates the money it needs.) However, in the light of the globalization and the less than sure utilization of private savings as investment or domestic investment it is very doubtful. 

Firstly, as long as cheap credit flooded the world both the government and private sector was capable to draw on significant resources, irrespective of the prospects of return. No real outcrowding effect was detectable for example in Hungary, albeit one can ague that interest rates were higher than would have been without government imbalances. But - due to cheaper foreign currency denominated loans - private sector was capable to finance itself despite the huge volume of government sector borrowing. Secondly, nothing can ensure that savings not absorbed by government sector will be utilized by the private production sector. Even though some impact of government imbalances on the distribution of scarce resources can not be denied the original - and even today very popular - model of direct outcrowding seems less plausible. (Or, more precisely, it became pro-cyclical. While excess liquidity existed outcrowding was not a real issue. but after the collapse of the financial markets it reappeared in an enhanced form. But this time not the individual governments affected the economy, but those states that has the ability to borrow in their own currencies. Therefore, US government and Treasury bonds replaced ECE government bonds in the portfolios of investors.) But it means that the relationship is more refined as usually perceived and as a consequence it is dangerous to assume that reduction of government debt will result in a similar rise in private investment or consumption. (Especially as imbalances has to be dealt with and deleveraging is a universal phenomenon.)

This is not independent from the other important issue, how far taxes are distortive regarding economic activity and whether tax cuts in the EU are measures to release economic forces from their captivity or rather government subsidies that should be banned just as direct government subsidies are. The starting point is again the concept that taxation - even if it is undeniably necessary - is a distortion of the market, regardless of its extent. Even if better or worse tax systems can be conceived in this sense this idea clearly creates a binary opposition, taxation opposed to the tax free economy.  And if someone presumes market distortion as bad or at least disadvantageous taxation can not be seen as acceptable, only tolerable at best.  A tax free economy should be treated as better suited for optimal distribution of scarce resources than an economy with taxation. As a consequence any kind of change in the tax system is rather a redirection of this distortion, a change of who is affected positively and negatively but not the removal of negative effects in itself. But as long as distortion of the tax system exists why not to treat this redirection identically to the direct susbidies? It expresses preferences just as subsidies do, it forms obstacles in the development of certain industries - some of them would be in a more advantageous position without the taxation - while offering more favorable conditions for others. 

Beyond these rather general considerations one can also ask whether tax modifications inside the EU can be justified? Even if one would argue that there are more market friendly and less market friendly tax systems and therefore modifications of the system reducing distortion can be designed (and it would be a serious counterargument to the above line of reasoning) it wouldn't eliminate a twofold problem inside a perceived common, single market, like the EU. Firstly, as even this counterargument would accept the possibility of tax modifications with negative effect on the economy (and serving as indirect subsidies), every single step would have to be judged individually from this perspective. Even though a common framework of taxation exists its effects are rather moderate, well reflected in the diversity of VAT system, even if the EU regulations set - nominally - a very strict limitations on their variations. But another problem - already tackled in one of my previous posts - persists: whether modification of the tax system is acceptable at all in a common and single market as the EU is usually seen? 

Every member state became a member of the economic community with a given architecture of its own national economy - brought in line with a set of regulations of the community - and joined this peculiar organization while it also had its own internal economic architecture. As soon as the integration was carried out - for example derogations were phased out - it was perceived to be part of this single common market. How far unilateral modifications of this internal architecture can be acceptable and when does this activity start to be contradicting to the idea of fair competition? The treaties are rather silent in this regard. They identify a series of fields were larger unity and conformity of the member states is expected an others were it is not desired rather arbitrarily? Why is it an aim of the EU to form a currency union - theoretically leaving no opt out for anyone - while tax systems are considered as almost exclusive territories of responsibility of national governments? It inconsequential at best. If the union is a given common market than every single unilateral deviation from the pre-existing conditions should be treated not only in the context of the respective member state, but in the context of the union as a whole. Favoring ones own country can be disadvantageous for others and such moves are considered as contrary to the idea of the common market in many cases. Why not in the case of taxes? Even in the case of tax cuts? Anyway, individual companies made decisions earlier according to given conditions and a deliberate change in these conditions undermine their reasoning, resulting in very real disadvantages that could not have been presumed.

Unfortunately not only the existence of the EU makes the practice of constant tax cuts a bit dubious from the perspective of a common market. Tax cuts can be interpreted as very direct subsidies for companies and their owners in the context of the difference between financial markets and investment into production sectors too. One of the reasons of the financial investments stronger appeal compared to investment into production (noteworthy is the growing share of financial companies from the GDP of the US in the last two decades) was the higher return on these asset classes. Seen from this angle tax cuts or tax rebates for companies are nothing else than premiums on this investment to make it competitive and attractive enough. But in essence it is the same as giving direct subsidies. The state gives public money to private companies in order to counter market forces' effect on their activity. Moreover, to the extent this assumption is true even the perceived results of such tax cuts and advantages - more investment in the private sector because of the higher return - can be questionable. If the tax advantage is just an investment premium to complement profit it is not certain that the additional income will be used this way. 

However, the matter seems to be complicated by the possibility to trade shares of individual companies on the markets. The rates of these shares are usually seen as a good reflection of their real market value, based on their activity. therefore on their real return in the form of excepted dividends. But it is not necessarily the case, it is an epistemological problem. Shares are traded as if they would reflect real activity, but it is not necessarily the case. In many individual cases it turned out that the company was capable to deceive the markets. (Remember the Enron.) Sometimes it is even beyond the individual companies and whole systems can fall victim of such practices, like the banking systems in Spain or ECE today, with their huge mortgages not written off or reduced to their real value (expectable return) rather kept overvalued in their books. In any case the possibility that the markets has only a chance to follow developments in companies and react to them with a lag - despite every kind of sophisticated means to evaluate their performances - because ultimately they have to rely on information supplied by those companies. And even if the markets are seemingly following real developments there is always a chance that their reaction is exagerrated. Who can really decide whether the volatility of oil prices in he last two-three years properly reflected the supply and demand and was not distorted by "speculation", the actions of market actors who only trade with virtual oil?

As long as the markets can rely on money creation in order to acquire different assets and trade them the very existence of the capability of banks to create money consists the chance to drive a bubble, completely distorting prices, dissociating them from "real return". And the same bubble devalues the investment in other sectors than the financial. And if the rising stocks themselves provides return for investors - thorugh derivatives, transactions like swaps etc. - not the dividend of companies, making the relationship between real activity and investment return even loser. As long as this situation exists, investing otherwise is crazy, making such premiums as tax cuts inevitable to attract capital. 

A logical solution would seem a regulatory drive making financial assets less alluring and redirecting capital to other sectors. It would necessarily mean a devaluation of financial assets as well, because the expected return on them would immediately decline making their present value lower. Unfortunately it would mean a devaluation of those funds that will finance the pensions of the next generations, the life insurances of individuals etc. On the other hand one have to face the reality: if the growth of financial markets in the last years was the result of a bubble than excess liquidity has to exist in the system. Up to this moment this excess liquidity was not removed, rather moved between different entities. Central banks and governments stepped in and took over private debt (one of the embodiments of this excess liquidity) and transformed it to public debt. But it is not elimination. Could it be seriously hoped that the problems would be resolved without its removal from the system? At the moment the solution preferred by markets seems to be fiscal austerity, cutting wages (but not reducing the debt covered by those very wages) and prices not only in order to generate growth through export, but in order to reduce the public debt that was grown substantially by the takeover of private debt. The issue is whether it is the optimal solution in terms of distributing the pain between social actors (as there is hardly any painless way to resolve the problems) or inflation, restructuring and other alternatives would offer socially more acceptable ways out of this mire. It certainly deserves wise judgment and a broader horizon than that of the "experts" and "analysts". Unfortunately even broader than the horizon of the usual politicians.

On taxation I.

As the elections in Hungary in April draw nearer and the result seems pretty sure - at least regarding the person of the next prime minister - more and more speculation appears on the probable economic policy of the next government. Some of these are driven by curiosity and goodwill, others rather by pure and badly veiled self-interest, but one thing is common these are speculations as long as no elaborate program is published. (However, I'm sure that no one will really have any idea until the government will take over its responsibilities and initiates the first measures, but it is not my point here to denounce any party's campaign strategy.) But the issue of taxes has a key role in almost every attempt, usually in the well-known form of the tax cuts = strong growth causality. 

The idea certainly has a popular appeal and precisely because it is so easy to assume that nothing else is needed for living better than cutting taxes. Hand over less to the greedy paws of the state and in return even your future prospects for higher income will be enhanced immediately, it is the perfect populist perpetuum mobile. But beyond this rather simplistic approach the issue of taxes is at the core of almost every attempt to revive economic growth and ensure its sustainabilty and not only in Hungary. Either in the form of tax cuts or at least as a restructuring of the system, placing higher emphasis on property and consumption taxes and relieving a part of the burden on labor as a means to raise the employment rate and improve the employment rate. (The underlying reasoning is quite simple: the only obstacle of employing more people is the high cost of labor and the high taxes as they are disincentives on working, especially when they are accompanied by generous social benefits. Therefore as soon as taxes will lower employers will hire people and those who were earlier reluctant to work due to high taxes will flock to the gates of factories. Everyone can judge this reasoning and think of possible supportive or counterarguments.) May point is not to challenge this idea - although I'm reserved at best towards this simple argumentation - rather I would like to focus on other aspects of the tax issue, like the real effect of tax cuts on personal income - as it is always assumed that it is positive for everyone - and the real nature of the restructuring, the so called "whitening effect" or the macroeconomic role of tax cuts or even tax hikes. All of these from the perspective of a layman, of course and without the pretence of being comprehensive.

Tax cut is a popular promise as it is too easy to assume that the lower the taxes are, the higher one's net income is. In a narrow sense it is usually true - and people even tend to assume the same for so-called restructuring as lower tax rates has an immediate and direct effect on net income level, while the offsetting measures are many times hidden, not to speak of the tendency of the individual to take into consideration the positive perspectives and perceive the negative ones as applying only to others - but taken into account a series of direct consequences this assumption is highly questionable and certainly would need closer scrutiny. (Apart from those idealistic views that postulate a self-financing tax cut, the result of which is a stronger economic activity bringing even more revenues than the earlier system. But it is one of the basics of science that perpetuum mobile is impossible, so let's not deal with this nonsense.)

It is easier to assess the effects of the tax restructuring, as its aim is not to lower the overall level of taxes. The basic proposals - always based on study how the different types of taxes affect economic activity - advises lower taxes on labour costs (in general, not only lower income taxes, but lower social contributions paid by employers and employees as well) and higher ones on consumption (usually VAT, but other taxes connected to retail too) as less distortionary and on property. The effect of higher income is certainly imaginary for a lot of affected people, as the higher VAT immediately offsets a part of the raise in net income. But the effect is different for the different income categories, depending on the consumption/income ratio and the savings rate of the individuals. Those whose consumption makes a higher proportion of their net income will suffer more. It is hard to tell how far this measure can offset the results of income tax cuts, it can be different in every individual case and depends on the reactions as well - scaling back consumption can offer some relief - but the usual assumption is that the lower income categories are hit harder as the weight of basic goods and services (foodstuffs, energy, transport) is usually higher in their personal consumption basket and these are the ones where the possibility for considerable savings is the most restricted.

Not surprisingly a similar effect is detectable in the case of the property tax - in most cases a real estate tax - a favorite choice for many experts. The supporting arguments are usually practical ones - it is impossible to hide a house while it is easy to do it with income (so everyone is guilty of tax fraud, isn't it?), it is easy to tax them and it is in line with social justice as richer people tend to own more valuable properties. Albeit these arguments do not seem to be quite solid ones - for the market value of a real estate depends only in part, sometimes even marginally, on ones own activity - but my aim is to highlight its effect on the reality of income tax cuts. For most people their house is the only or the far most valuable piece of real estate their own and only a very few has capital return on them. (Beyond the advantage of not paying rent for their homes.) Therefore they can only service this tax from their income from work or labour (or in some cases from other incomes, however in case of many countries the wage is the dominant form of personal income for the bulk of the population.) As soon as the real estate is not used for some aim to yield return the property tax becomes in effect a hidden income tax. (Or even not so hidden if someone presume that it is a tax on the indirect income of being free of rental costs for housing.) But in both cases it is a tax levied on earnings and not on capital returns. Nevertheless it could have merits, for eyample a redistribution of wealth, bringing back capital to the economy etc., but it offsets income tax cuts and in a very arbitrary way. Due to the low influence on the market value of one's home, due to soaring real estate prices during boom years and protracted, many times incomplete correction in worse years. And due to the fact that in several ECE countries the ratio of real estate value to net income is probably higher than in many Western countries. It also means that the offsetting effects are different for everyone and only general assumptions and hypothesises can be put forward without a thorough analysis, but one can safely assume that a property tax can easily hit not only the lower income categories, but the middle-class, depending on the home value/income ratio. (The much advised solution to make a property tax deductible from the income taxes could eliminate the effect on the middle class, but wouldn't resolve the problem for lower middle class people and for those in the lower income categories. And selling one's home is also not necessarily a solution, because it would only capitalize a hidden income - the lack of home rental costs - in the form of a financial saving and the loss of income would only be avoided if the newly emerging rental costs would be covered by the return on this capital entirely.)

But these are almost explicit implications of the tax restructuring approach, although not necessarily recognized by those who would be affected. (And the problem of the effect on different social categories still persists, it can easily turn out to bring advantages only to those in the higher income categories.) However, the income tax cuts has a very similar offsetting effect, as long as they are not self-financing (and I would dismiss this assumptions, at least in the short term, because I try to assess the immediate effect on income) or not financed from new sovereign debt issuance. So, one can assume that tax cuts are accompanied by spending cuts. If these are not confined to the laying off of unnecessary public administration personnel (a phenomenon certainly existing, but the extent of which - and conversely the extent of the savings offered by this usually popular move - is hard to guess)  the implications will be higher implicit or explicit costs for public services. (People will either be charged with a higher sum for these or will be obliged to buy them from private entrepreneurs instead receiving them from the state on a lower price etc.*) The first aspect of this offsetting effect is the inflationary one, higher explicit prices for public services will drive the CPI upwards and they will remain at that level even after their statistical effect faded in the next year. (However, some savings can be achieved at the personal level by not buying these services, because earlier everyone paid for them a usually lower individual price in the form of taxes, while from this moment only those would be charged with a higher one-time price than the tax was who effectively would use them. But again it is not easy to make estimates regarding this effect and apart from the case of significant cost savings due to higher efficiency - or because of a more depressed demand due to visible an higher prices - the aggregate sum spent on these services would remain equal, only its distribution would be different. But its analysis is far beyond the means and possibilities of this blog post.) However, beyond inflation one can assume another offsetting effect, the effect of almost compulsory saving. Scaling back the state (spending cuts) usually implies the emergence and reconfiguration of systems like pensions or health insurance on the basis of self-provision. Even if it won't be obligatory legally it would be hard to avoid paying these contributions, because the cost sparing accessibility of public services would depend on them in case of necessity (classic health insurance) or they could mean the difference between a pension barely higher than subsistence level and a decent sum. However it is not necessarily a meaningful investment in the future, as it is rather a forced consumption and obligatory saving. (A kind of "békekölcsön" or "hadikölcsön".) And it has very similar effects and probably would have the perception as paying taxes. At this point the negative effect is more probable on the lower income categories, as for the higher earners, who even vefore the tax cuts had enough income to save a considerable amount, it is a meaningful choice between different risk-reducing strategies and investment forms. In general I would hypothesize that the effect of tax cuts - due to almost compulsory savings - would be only really positive in higher income categories and could even mean a decline of freely disposable income in the lower categories. And certainly surprise many from the middle class.

However, toothpaste advertisers will certainly drew our attention to a possible source of higher revenues, the "whitening effect". It is usually assumed that lower taxes will inspire people to legalize their earlier grey or black incomes, because - as this reasoning assumes - their incentive to hide it was only the horrifying nominal or marginal tax rate. (The implicit assumption of the "whitening effect" is the existence of a highly effective tax administration that can detect tax evasion with a high certainty making this practice risky enough to convince earlier evaders to accept the lower tax rate.) Nothwithstanding the sorrowful fact that the highest estimates of grey economies in the EU are usually produced for low tax level countries (Hungary is of course overtaken in this sense by Romania, Slovakia, Estonia, Latvia, Bulgaria, one can imagine the mood of our experts etc.) the assumption is not in compliance with the basic assumptions of the idea that lower taxes generate more work and with higher labour input higher growth. The main argument behind the reasoning that low taxes = higher employment (more work and more employed) refers to the willingness to work more if the income is taxed more benevolently. The favorite tool of measuring the effects of the tax system is marginal tax rate, i.e. how much can someone retain from one unit of additional income. However, if one considers black economy properly, it means that a significant part of one's income is taxed with a zero rate, therefore the marginal tax of grey and black incomes is zero. So the advocates of the "whitening effect" (while relying on psychological arguments, usually abhorred from if they are used to doubt their economic models) at the end state that people - contrary to their basic premises - will be ready to do the same work with the same intensity if their marginal tax rate will be raised. (And not insignificantly, as any natural number is infinitely more than zero ;) ) Therefore it is highly improbable that people will legalize their untaxed income, or if they do then labour input will decline in the economy, generating less output as the marked raise of the marginal tax rate  is a strong disincentive for work. 

Even if one dismisses this conclusion as absurd (I wouldn't be sure, people are usually not flocking to legalize their incomes even with lower tax rates as long as they are not really deterred by the high risk of being punished for tax evasion, but in this case - as it recently happened in Germany when someone offered for sale a CD with the alleged data of alleged tax-evaders - they usually do it on very unfavorable terms - i.e. high tax rates - as well) the extent of the cut in the income tax rates to unearth hidden incomes is not easy to estimate and certainly depends on the total income/grey income ratio. Because the higher one's illegal income as a ration of the total income is the lower his/her effective tax rate calculated on this total income is. Therefore only a more pronounced cut can bring enough incentive to legalize income. One can hypothesize that people with only occasional grey earnings will more readily pay some tax with a smaller cut (although it is not entirely consistent with the marginal tax incentive idea), while those who are in fact employed as grey workers - either entirely paid under the table or having officially a lower salary than they are receiving - will be convinced only by a very marked step on this route. This is not entirely hypothetic, as the main aim of these cuts is usually to convince the latter category- who are also conceived as the potential source of significant additional budget revenues. (Besides these rather automatic considerations one can also refer to the problem of labour costs beyond the income tax, social contributions and especially those that are paid for by the employer. Even in case of a significant tax cut these elements of labour cost can easily deter employers to offer a legal full salary, they can instead offer a splitting of the gains from the tax cuts - higher official salary with the same or slightly higher net income -, what would also be in fact a higher taxation of these grey incomes.) 

Anyway, one can safely conclude that tax cuts in themselves won't bring more freely disposable income for everyone. (It is important to note that one's income can nominally be higher, but with inflation, higher personal spending and almost compulsory savings the freely disposable income, the part of one's earnings that can be distributed freely into different consumption goods or directed into investment etc. can be even lower than before and ultimately this is what counts in assessing whether one is better or worse off after the tax cuts.) The effect of tax cuts can hardly be assessed in general, it should rather be done with the analysis focusing on different social groups, even though the macroeconomic effects are easier to grasp. But maybe for the individuals their personal fate has a precedence over macroeconomics, however shortsighted it be.

(So much for today, I will continue the analysis of the macroeconomic peculiarities in the next post.)

*There is always the possibility of magical savings due to higher efficiency of private providers, but the empirical evidence for this is controversial at best, therefore I won't make an attempt to guess its extent.

Democracy victorious

Our Moldavian very European democrats are in action. Instead of complying with the current constitution and dissolve parliament after the failure of electing a new president, they decided to create a new one. Not that I had any illusion and I'm sure that for those who thought of them as the champions of democracy it will even be a  reassurance in their blind faith. However, the nasty communist did not attempt this move. Maybe they were so rotten in their souls that they couldn't even think of this  extraordinary democratic solution for a constitutional impasse and went to the polls (to the polls, oh, what a dictatorship!) again instead.

Political economy of the West - updated

I always tried to avoid being boring and repetitive (however the resulting decline of posts can only help in the latter, but unfortunately enhances the former) but one of my permanent assumptions mentioned on this blog is that contrary to the popular - and evidently self-interest driven - portrayal of Eastern politicians their are not different from their Western peers. A very few of these people is the proverbial knight of public interest as opposed to the individual or group interest and unshakable champion of meaningful reforms delivering better results for everyone in the long term. It is quite instructive to take a look at Germany.

Germany is obviously a Western country, where the social democrats were ousted from power last September and their place as junior partner in a coalition besides the christian democrats was taken over by the liberals. For many - among them fro the respective parties - it was the realization of a dream coalition, much awaited for 11 years, since Helmut Kohl lost an election in 1998. Some commentators embedded the events into a grand narrative of overall decline of the left, predicting a loss of power for Great Britain's Labour for this May (once a certainty, now not so sure) and imagined an EU almost without leftist governments. Others (and the same commentators as well) pointed out that the electoral result of the liberals, an all time high, almost 15% is a sign of a strong desire for profound change in Germany. Especially, as the party run on a program with a very market-friendly agenda: tax cuts (self-financing ones, of course through stronger economic activity), health care reform, deregulation were the key points, but at the same time they emphasized a modified approach to the social systems, a more friendly one, in order to erase their stigm being the party of "social coldness" (soziale Kaelte). As the conservatives were always perceived as a market oriented party many awaited rapid changes.

The result: something completely different. After their first 100 and a few days in power the coalition seems to be nothing else then the scene of endless brickering, conflicts, their party leaders - except the chancellor, Angela Merkel - attacking each other at every opportunity despite the efforts to bring peace. Moreover, it turned out that the key proposal of the liberals are not so welcome by their partners as they expected. In some cases on practical grounds: with a huge debt burden taken during the most severe phase of the crisis the conservatives are reluctant to pledge themselves to the requested tax cuts s they are not convinced of the myth of self-financing tax-cuts. In other cases the difference is one of principles: the smaller - Bavarian - conservative party opposes vehemently the idea of the introduction of a single lump-sum fee for health insurance for everyone, independent of their income etc. (The liberals idea is to compensate the obvious social disadvantages - people with lower income paying higher fees in proportion of heir income than people with higher income and/or more property - through the tax or the social system. It is not only contrary to their proposals regarding a simpler tax system, but probably would be mor expensive than the present system of direct state contributions to the individual helth insurance institutes as compensation of their losses. According to some estimates of the Ministry of Finance it would cost about 17 billion euro yearly, while the present system required "only" 8-9 billions last year.) The Bavarians announced that it is for them an issue of life and death, they can't accept any from of a lump sum fee.

Although these are not the only contested issues (for example a huge debate on the so-called Hartz IV system, a social assistance system for long term unemployed broke out recently) maybe even so much is enough to illustrate the depth of the problems. The first reaction was - beyond the inevitable surprise - some commentaries on Merkel, whose sympathy for ideas of social democratic origin was underestimated by her liberal partners - followed the conclusion. However, it was rather a reflection of the popular mood of the Germans, who rapidly withdrew their support from the liberals (they lost a half of their voters during this period) not only because of the above mentioned problems, but because they soon became suspicious of clientelist politics. (In a package of tax cuts they pressed for lower VAT for hotels and restaurants but it was soon revealed that the respective business has no intention to pass it to the costumers - i.e. lower its prices - and informations surfaced on huge donations to the party from hotel owners.) Their reaction was somehow confused: raising the pressure on their partners regarding tax cuts - irrespective of the situation of the budget - and health reform. (The story is very similar to the story of the Hungarian liberals from 2006, the series of similarities extends even to the continuous reference to the sanctity of the coalition agreement - a text with sufficiently opaque and vague formulations in this regard.) Even after opinion pollsters shared the results of their surveys with the public: no one really expected them to deliver the exact promises they made, especially not the tax cuts, thought not too much credible by everyone - rather changes in the relationship of the sate and its citizens, a field where they didn't even had at the end a single idea.

What can be the conclusion of this familiar story? (Familiar from Hungary, a coalition rapdily loosing the support of the population - according to the last poll more than three fifth of Germans considers this coalition an alliance of parties that do not fit to each other - and politicians misreading the signs sent to them from the public and struggling to keep power in a key province in the country at the elections in May.) Not the too easy prediction of inevitable failure of the government, rather the necessary caution for every politician. First, ideas popular in opinion poll can easily turn out to be unpopular when not only the bright side, but the trade offs has to be faced. Secondly, it is dangerous to be carried away by someone's own zeal and think that the people are enthusiastic about the same points of their program as they themselves. Thirdly, despite the dire situation of the left, these societies didn't make a u-turn and embraced the anglo-saxon type of free-market capitalism. They are rather not only divided in this sense, but clearly looking for solutions to preserve as much from the welfare state as can be. Not very insightful conclusions, but as in ECE politicians instinctively or consciously accepting them are portrayed as villains, maybe not is not completely useless to point them out.

It was a long time ago I posted something and it seems the topic was almost the same as this post. However, this one was written in a bit different genre. Not too much difference, but some justification. ;)

It is so familiar!

Actually I'm not really surprised but as usual the idea of the Hungarian politicians being uniquely stupid and villainous, runing away from every copnforntation with the popular will is widely shared in this country. Due to the recent decisions of the Constitutional Court it was cpmlemented by another complain, that this institutions is a unheard defender of social rights, blocking every reasonable attempt to gain competivity with reforms. But this is only possible in this doomed country with its exceptional political and institutional system.
The last few weeks provided a lot of counterexamples. Well, not in the form of the emergence of bolder politicians and less socially oriented judges, but as examples from other countries in Europe (and funnily not only from ECE). It began with the Latvian Constitutional Court's verdict on the pension cuts, declaring this measur void. The Romanian prime minister had a very spectacular egg-dance recently, when pieces of new legislation were revealed and immediately denied. No lay off of 100000 employees from the public sector at once, now lower pensions, even if earlier it was almost explicitely predicted. (The method is almost the same as in Hungary. Some analysts express their desire, put forward as the only possible solution, the politicians tactfully refrain from comments - and maybe in the background they even reasure them and ask them to do it - giving the impression that they accept it. It soon ensures the support of these important figures, but as soon as they confront the popular resistance they realize that votes are counted in hundreds of thousands and not in dozens.)
But the most spectacular situation occured in Germany. In this country the Christian Democrats and their long-term allies the Christian Socialists from Bavaria could at last fulfill their dream and after five years of great coalition with the social democrats form a new government with the liberals. The liberals were running a campaign based on promises of health care reforms, tax cuts, relaxation of the labour market regulations etc. Analysts said that in fact it is a proof of the decline of social/democratic ideas and of the readiness of Europeans to embrace free market as it is understood in the anglo-saxon model of capitalism. (Even though the liberals proposed a program in which they tried to emphasize their human face as well.) However, after 100 days of rule, with some tax cuts delivered, ideas of health care reform unveiled their popularity plummeted. Certainly not independently from the permanent brickering in the coalition, but they also have to face more porfound problems. There seems to be quite narrow space left for further tax cuts without major cuts in social and public services. (Even in case of the passed tax cuts they atre for many counter-balanced by a rise in the prices of public services due to a newly impsed VAT regulations and due to the loss of public income at the local level. And mewnhile it turned out that the liberals insisted on a controversial tax cut for hotels after receiving a very significant contribution form a hotel owner.) The idea of an equal a basic, contribution of to health care is seen as disadvantageous to the lower income categories and favoring the higher ones. Moreover, liberal ministers do not seem to be too competent. And at the end the Constitutional Court ruled that the new system of unemployed support, called Hartz IV is unconstituional, because it is not providing people with the basic needs for their life.
What was the liberals reaction after a thorough investigation of their situation: people are not rejecting reforms, they are disappointed with their slow pace! Let's make it faster! It is so familiar. The Hungarian liberals always nurtured this comforting idea, incaapable to admit that they views are not shared by the majority of the people an dthey ended up as a collapsed party. Not thet FDP will have the same fate necessarily. But maybe not only Hungarian politicians are crazy and villainous species.

Hungary - once again left behind

For years the idea of Hungary having a unique and unparalleled crisis, that could not happen elsewhere was a dull, repetitive syntactic element of almost every commentator's opinion. Reasons were easy to find: nowhere was such a bad government identified, no society was more attached to its socialist past, no politicians were so fearful of losing elections, no country so corrupt. But at least, being the worst among every ECE country was a mazochistic consolation for supposedly having lost the forerunner position. (However, I have many times bored my few readers with this topic.) We even had and has our own, specific and particular crisis that was caused by our own government. (Yes, even today.) 

And now the world or the fate again turned against this small and much-suffered nation and with the effects of the crisis on state-households slowly, gradually but pronouncedly unfolding everywhere others are again overtaking Hungary, or at least almost literally repeating everything that was once considered as unique and not easily reparable mistakes. Not only in one country, but in a series of states.

Greece is the obvious example in many sense, with accounting tricks, giant budget deficit (once the Hungarian reaching 9,2% of GDP was described as world record and a clear sign of exceptional insanity, than what about a value somewhere between 13,7% and 15,5%?), social resistance to changes, a deficit reduction program considering raising revenues, not exclusively relying on budget cuts etc. 

But something similar happens in neighbouring Romania, the country of a small miracle recently, many times perceived as the next economy overtaking Hungary. After a year of incompetent governing, when politicians was not ready to take energetic action and accept unpopular measures because of the presidential elections at the end of last year, a nominally right-wing government announced some steps not so unfamiliar for people knowing something about Hungary's last few years. A minimal expected tax on companies, change of the tax base effectively raising the tax rate for most of them, simple lay-off of budget personal instead of "structural reforms", introduction of new taxes, like the "junk food tax", preservation of the privileges of the very rich, dubious contract in motorway construction, and immediate retreat as signs of some resistance appear. (The prime minister denounced his minister of finance regarding the lay-off of about 100 000 people from the state sector, and described proposals from ministries on new impositions as ideas of unexperienced people.)  What is clear: there will be weaker domestic demand in an economy earlier fueled by consumption and the government's only hope is EU funds and investment. (What would be badly needed, the minister for economy announced that his intention is to introduce electricity in every Romanian villages in 2012. Think of it, EU 2010!)

But the most ridiculous series of events unfolded in Germany. The liberal party that entered the government as junior partner after the social democrats lost at about 10% of their vote share at last year's elections, in September, represented a very straightforward free-market agenda, and proposed changes on the very same fields as their Hungarian counterparts, for example lower taxes with fewer tax rates (and elimination or reduction of some taxes usually hitting the very rich) turn towards more private health care system, with a unitary contribution for everyone, irrespective of their income. As the state household of Germany is not in a good shape (and as according to some observers the chancellor, Angela Merkel in the last years became more social democratic) it led to very loud and heated clashes inside the coalition. Albeit a meeting of the party chairs last weekend served as a solution for the internal fights that threatened to deepen the problems of a coalition that was welcomed by its members as the realization their dream coalition for more than a decade, but obviously made a very week start, it is not clear whether this attempt will be successful in the long run. And the similarity to Hungary is more than striking. An intransigent liberal party is pushing an agenda against the will of a majority and against the possibilities, always referring to the coalition agreement and causing upheaval. (Ok, in Germany the minor Christian social party also has some role in this situation, as they try to impede the erosion of their voter base with a confrontative image, acting as a counterbalance of the liberals.) 

I won't say, that the fate of the German coalition will be similar to the Hungarian one, but I somehow fail to see the prudent politicians, willing to make personal sacrifices, boldly acting against temporary unpopularity etc. And even the Polish government (in a country which at last, contrary to forecasts, avoided economic contraction) fails to bring budget deficit under control for electoral reasons. We are once again lost, others leading the pack.

Something worth to read - from Barcelona

One piece, one author, two versions. Worth to read...