Globalization and taxation

In recent times, amidst weak global economic prospects and rising protectionist sentiments, an intense debate about globalization has resurfaced. Peter Egger, Sergey Nigai, and Nora Strecker have a new paper which adds to the debate by raising the possibility that globalization may have had the effect of increasing the reliance of governments on less mobile middle-class tax bases. They examined a taxation database of 65 countries in the 1980-2007 period, and find significant effects as globalization gathered pace post-1994. 

Their narrative is simple. As economies open up and globalises, businesses and high-income individuals become footloose or to paraphrase Charles Tiebout, "vote with their feet". One way countries compete to retain and attract them is by lowering the corporate and marginal tax rates. In the process, among developed economies, on the average and when there is limited induced economic activity, tax revenues from these sources decline, forcing governments to rely more on the relatively immobile middle-class incomes. The authors write,

When goods and factors became relatively more footloose after 1994, evidence suggests that OECD governments found it more difficult to tax (arguably highly mobile) high-income earners. Moreover, in light of competition for such often high-skilled individuals, countries have further sought to decrease those individuals' personal income tax rates and compensated the foregone revenues by increasing taxes on individuals with middle incomes (and lower bargaining power than high-income earners)... under the threat of flight of high-skilled workers, governments reduced taxes for mobile high-income earners and increased them for the immobile middle- and upper-middle-income classes. 

Consider this. Middle-class income tax rates have increased by around two percentage points across 65 countries, whereas corporate and marginal tax rates have declined significantly. 

And, for the OECD countries, the burden has been carried by those at the middle, especially post-1994.

This effect is likely to get amplified as other technology-driven trends like e-commerce and remote working gains ground. The losers of globalization will perceive that their jobs are being taken by foreigners and their tax rates are rising. The widening inequality will exacerbate the discontent and generate more backlash against globalization.

There are no easy solutions. A two-pronged response may be the only way forward. One, the losers will have to be compensated by way of a stronger social safety net complemented with re-skilling programs that equip them with occupational mobility. The corollary of this though is to increase tax rates on the winners so as finance the benefits for the losers. But this redistribution runs into the Tiebout problem.

This brings us to the second response, which is about international coordination on taxation policies to prevent a race to the bottom. More so at a time when the global economy is weak, investments anemic, and international trade stagnant, and income growth confined to the highest earners, any competitive tax reduction is most likely to be a zero-sum game for all countries put together. No country gains without hurting others. In other words, tax reduction merely increases arbitrage opportunities without any commensurate increase in productive efficiency and output. In the absence of some form of global coordination or restraint, economies will be encouraged to indulge in competitive tax reduction that would only increase the relative tax burden on the middle-class everywhere. 

Financial incentives and teacher performance

Sometime since I did my last education post. Incentivizing students and teachers with cash payments to improve their performance has been a controversial area in education. The evidence on both have been mixed.

Roland Fryer has been a pioneer in experimenting the use of financial incentives, both individual and group-based, to prod students, parents and teachers to perform better. His latest research paper comes from a randomized control trial of teacher incentives on student achievement in over 200 New York City public schools. His conclusion runs contrary to findings from developing countries,

"I find no evidence that teacher incentives increase student performance, attendance, or graduation, nor do I find any evidence that the incentives change student or teacher behavior. If anything, teacher incentives may decrease student achievement, especially in larger schools."

Though schools had the flexibility to fashion their own incentive structure, a vast majority of schools choose to distribute incentives equally (this could have under-cut individual initiative) if teachers achieved their performance targets and also preferred group-based incentives (which may promote free-riding).

Prof Fryer examines the failure of incentives on teachers from four perspectives - incentives may not have been large enough; incentive scheme was too complex; group-based incentives may not be effective; and teachers may not know how they can improve student performance. He argues that the most probable reason for the lack of response with incentives in the NYC schools is that the incentive scheme is far too complex and provides teachers with too little agency.

He examines the results of the Project on Incentives in Teaching (POINT), a pilot initiative in Nashville, Tennessee, which finds that a larger incentive in schools was still not any more effective. He argues that group-based incentives are more likley to work when the number of teachers in each school is small (compared to New York's more than 50 in each school). When teacher numbers are small, as in developing countries, monitoring and imposing cost on those teachers who shirk their responsibility is easier.

However, Fryer points to a study by Victor Lavy in Israel on success with teacher incentives in schools with an average of 80 schools. He found that when teachers were incentivized on the average number of credit units per student, the proportion of students receiving a matriculation certificate, and the dropout rate, there was a positive and significant impact on the average number of credits and test scores.

It is not possible to draw too many conclusions from these mixed results. I have already blogged about the difficulty with implementing teachers-based financial incentives. Here are a few observations, some of which have already been dealt with in the earlier posts

1. Prof Fryer's disappointing results stands in contrast to apparent successes with incentives in developing countries. Given the much lower baseline achievements in developing countries, it is plausible that smaller incentives may be effective. In fact, the much lower level of standards and consequent higher potential for marginal improvements in developing countries means that it is possible to design simpler incentives that teachers will find easier to respond to.

2. The long-term impact of financial incentives, especially in professions like teaching and activities like studying, is largely unknown. Does extrinsic motivation crowd out (and even kill) intrinsic motivation? A student being incentivized to read a book (or write an essay) for Rs 50 for sometime is surely going to expect (only the degrees vary) some similar incentive every time. The same psychological chain of thinking works with teachers and parents. Without fully understanding its consequences, pumping for financial incentives is evidently dangerous and could have potentially disastrous consequences.

3. There is the difficulty of identifying when (and which environments) do we offer financial incentives. In most developing country environments, even small supervisory and monitoring improvements can achieve disproportionately large improvements in performance. Most often, the same investments if made in improving the capacity of the supervisory system can achieve gains that are far higher than those with cash incentives. It is like jumping high to pluck a low hanging fruit!

4. Finally, there is the issue of scaling up such incentives. It is one thing to run a pilot with 500 or 1000 schools, and a qualitatively different task to do it in an entire state. Forget the problems with quantification, gaming of the performance parameters, apples-to-apples comparison, and all other qualitative challenges associated with having a reasonably widely acceptable performance monitoring system. Implementation on scale generates the very real and almost inevitable risk of the incentive ending up as an entitlement. Teachers could start demanding incentives for even complying with their routine duties and responsibilities, for which they draw their salaries in the first place. A corollary to this is the political impossibility of withdrawing or scaling back, even after the basic and initial objectives are achieved.

5. Performance parameters become a moving target once the stakes are raised. As long as these performance parameters are merely captured and not acted upon, except in cases of the negative outliers, there is little incentive for participants to game the system. Once the stakes increase, and financial incentives do raise the stakes (atleast for some participating teachers), incentives to game the system and manipulate results get triggered off. Staying ahead of this game is difficult, even for mature systems (as New York City, with its grade inflation on standardized tests, found out recently).

6. A less controversial and surely less risky approach with incentives is to have in place a carefully designed plain vanilla approach to incentives. Such an incentive structure would either offer (directly) non-financial incentives (say, vacation pass), or appeal to intrinsic motivation (public recognition or acknowledging with certificate, teacher of the month), or selectively reward a few bright spots (say, cash incentives to the best 10 teachers). All of them carries some or all of the aforementioned dangers. However, its much less scale and scope, eliminates many of the dis-incentives and makes its effective management possible.

Nobel Prize for the times

This year's Nobel Prize in Economics could not have been given to a more appropriate set of people (my prediction notwithstanding!). The persistent high unemployment rates in the US during the Great Recession raises serious questions about classical theories which predict that the labor market will clear automatically (by way of wages falling thereby enabling labor supply to match with demand automatically).

The "austerians" have been attributing the persistently high unemployment rates to structural factors associated with changes in the economy in recent years, and feel that the high rates are only a manifestation of a "new normal". The implication of this is that any effort to boost demand by way of additional government spending would have no effect. In contrast, their opponents see this as a manifestation of weak demand and anemic investment environment. They therefore advocate more stimulus spending and monetary accommodation to enable effective utilization of idle manpower and encourage businesses to proceed with their regular investment decisions.

Professors Peter A Diamond of the Massachusetts Institute of Technology, Dale T. Mortensen of Northwestern University and Christopher A. Pissarides of the London School of Economics won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel "for their analysis of markets with search frictions" where buyers and sellers do not match themselves automatically. Specifically, they "spent decades trying to understand why it takes so long for people to find jobs, even in good economic times, and why so many people can be unemployed even when many jobs are available".

They argue that it takes time for unemployed workers to be matched with the proper opening, since neither people nor jobs nor employers are identical. These findings are relevant for markets with differentiated products — like labor and housing - which do not fit into the classic supply-demand equalizing paradigm. In these markets, "heterogeneous sellers confront heterogeneous buyers, and it takes time and effort to find appropriate matches".

On a broader canvas, their work is an important component of "search theory", which has been applied to many other areas, like money systems and venture capital markets. Labor economists talk about firing costs, family economists talk about divorce costs, and housing economists talk about shifting costs, all of which comes in the way of automatic market adjustments. Their findings also point to the possibility of unintended consequences like unemployment benefits ending up prolonging joblessness by making it less costly to be without work.

As NYT reports, Prof Diamond said that one of the implications of his work was the fact that more fiscal and monetary stimulus was probably necessary to speed up job growth, "The slower it happens, the more workers lose their skills and stop searching, and so the process goes more poorly after that". Rejecting the "new normal" unemployment rate hypothesis, Prof Diamond says, "Workers and employers will adapt to what will make the economy function. I see no reason why, once we get fully over this, we won’t go back to normal times".

Professor Mortensen argues in favor of additional measures to get credit functioning more normally, and in particular to make it easier for small businesses to get loans, were crucial to reducing unemployment, "From my perspective the problem right now is not the labor market. What’s happening in the labor market is a symptom of more complicated problems with the financial market".

In many respects, this prize may also be seen as the final triumph of Keynesianism itself. While Keynes had generically argued that economies need not automatically recover from a recession, this year's winners have shown that much the same applies to the labor market for varying reasons. Edward Glaeser who has this excellent summary of their research, also has the most appropriate tribute,

"Rarely has the prize committee been better able to match the honored work with the moment."

See Mostly Economics for a nice summary and and excellent graphical explanation by Econospeak of the Beveridge curve relationship and the difficulty of assessing any equilibrium unemployment rate.

Nobel prediction 2010

My prediction for the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2010 to be announced on Monday are

1. Richard Thaler and Robert Shiller, or
2. William Nordhaus and Martin Weitzman

The first two represent arguably the most influential trend in economics today - the use of insights from behavioural psychology to explain both macroeconomic and microeconomic phenomena. The later twosome are unquestioned leaders in the increasingly important field of environmental economics, especially in studying the impact of climate change.

In light of what the world economy has been undergoing over the past three years, the two people who are certain not to get are Robert Barro and Eugene Fama. The trade economists like Avinash Dixit, Gene Grossman and Elhanan Helpman may have lost their chance (or may have to wait for some more time) once Paul Krugman won the single award in 2008.

Both predictions are a repeat of my unsuccessful prediction of 2009. Hopefully, "this time is different"!

Return of the political economist?

By awarding the The Sveriges Riksbank Prize in Economic Sciences to Elinor Ostrom "for her analysis of economic governance, especially the commons" and to Oliver E. Williamson "for his analysis of economic governance, especially the boundaries of the firm", the Nobel Committee may have signalled the return of the political economist to the centerstage of debates on economic issues.

Apart from signalling the convergence between economics and other social sciences, there are two more interesting things, of great relevance now, about this award. One, in keeping with the tumultuous events of the recent months, the prize highlights attention on more broad-based market failures and underlines the importance of non-market institutions and arrangements in addressing such failures. Second, amidst all the euphoria surrounding outsourcing and shrinking of firms, the work of Williamson in particular, sounds a note of caution and points to the need to revisit Ronald Coase's analysis of transaction costs.

As Edward Glaeser writes in an excellent post, Prof Williamson saw the limitations, as well as the benefits, of hierarchies and organizations. His analysis focussed on market failures due to bounded rationality, asymmetric information, imperfect contracting, adverse selection, ex-post opportunism, and so on. As Glaeser writes, Prof Williamson focussed on "peer group associations and hierarchies... emphasizing information asymmetries and the difficulty of ascertaining the productivity of particular workers... argued that a simple hierarchy with workers, ground level managers and an entrepreneur was a remarkably efficient way of handling production when information was imperfect."

Ostrom’s work focuses on the commons, such as how pools of users manage natural resources as common property. As MR correctly points out, Prof Ostrom saw not the tragedy of the commons but opportunity of the commons and the relevance of social and community institutions and conventions in addressing widely prevalent market failures in many areas of sharing of common public resources - grazing, fishing, irrigation etc. It writes, "Ostrom's work is about understanding how the laws of common resource governance evolve and how we may better conserve resources by making legislation that does not conflict with law."

Prof Ostrom's work goes beyond the conventional public-private divide and focuses on how "pools of users manage natural resources as common property" and thereby overcome the market failures arising from the tragedy of the commons. There are numerous examples of traditional governance structures, where the commons users "create and enforce rules that mitigate overexploitation". As Prof Ostrom has written (and also here), "When users are genuinely engaged in decisions regarding rules affecting their use, the likelihood of them following the rules and monitoring others is much greater than when an authority simply imposes rules".

Paul Krugman sees the awards as a recognition of the New Institutional Economics. See Mark Thoma, as always, for the exhaustive links.