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Finance 30220: Macroeconomic Analysis
Recent Macroeconomic Controversies
Distribution of Household Income: 2004
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
Under $2,500 $12,500 to$14,999
$25,000 to$27,499
$37,500 to$39,999
$50,000 to$52,499
$62,500 to$64,999
$75,000 to$77,499
$87,500 to$89,999
Source: US Census Bureau (www.census.gov) Total Households = 112M
Median Household Income = $45,000
Average vs. Median Income (1979 = 100)
80
85
90
95
100
105
110
115
1979 1981 1983 1985 1987 1989
Mean
Median
Source: US Census Bureau (www.census.gov)
US Income Quintiles
$25,678
$43,588
$68,994
$147,078
$9,996
50.1%
23.1%
14.6%
8.7%
(3.5%)Lowest 5th
2nd Fifth
3rd Fifth
Fourth 5th
Highest 5th
Source: US Census Bureau (www.census.gov)
The Lorenz Curve
12.2
26.8
49.9
100
20
40
60
80
3.50
102030405060708090
100
0 10 20 30 40 50 60 70 80 90 100
% of Households
% I
ncom
e
US Perfect Equality
The Lorenz curve plots the cumulative distribution of US income
The Gini Coefficient
0 = Perfect Equality
1 = Perfect inequality
BA
AGini
The US currently has a Gini coefficient of .45
The Gini Coefficient has been steadily rising in the US from a low of .35 to a current level of .44
The increase in the Gini coefficient has accelerated in recent years.
Rising Inequality in the US?
The Good Old Days: Economic Growth from 1947-1973
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Ann
ual G
rowth
Bottom Fifth 2nd Fifth 3rd Fifth 4th Fifth Top Fifth
The Times, They are a Changin’: Economic growth from 1977-1989
-1
-0.5
0
0.5
1
1.5
2
2.5
3
BottomFifth
2nd Fifth 3rd Fifth 4th Fifth Top Fifth Top 5%
Why is income inequality rising?
New technologies favor skilled labor (an increase in the “skill premium”)
Increasing importance of international trade Decline of labor unions
Should we be doing something about this?
And if so, what?
Bracket Old Rate New Rate
$0 - $6,000 15% 10%
$6,000 - $27,250 15% 15%
$27,251 - $67,550 28% 25%
$67,551 - $141,600 31% 28%
$141,601 - $307,300 36% 33%
$307,301 + 39.6% 35%
The Bush Tax Cuts of 2001 & 2003 Had four main components:
Across the board reductions in marginal tax rates
Increase in the child tax credit, and a reduction in the “marriage penalty”
A repeal of the estate tax
A reduction in the tax rate on dividend payments
Tax Bill Cost in Current Dollars (Billions)
Cost in 2003 Dollars (Billions)
Cost as a % of GDP
Kennedy Tax Cut (1964) $11.5 $54.9 1.9%
Reagan Tax Cut (1981) $38.3 $68.7 1.4%
Bush Tax Cut (2001) $73.8 $75.8 .8%
Bush Tax Cut (2003) $60.8 $60.8 .6%
The bush tax cut was advertised as “the largest tax cut in history”. However, when put in equal units, the Bush tax cut was actually relatively modest compared to earlier policies.
What do we mean by the “cost” of a tax cut, anyways?
Suppose that the Johnson family has a household income of $50,000. Currently, the income tax rate is 20%.
Under the current tax code, the Johnsons pay $10,000 per year in Taxes.
If the government cuts the tax rate to 10%, then the Johnson’s tax bill falls to $5,000
The cost of the tax cut is the $5,000 in lost revenues
Suppose that a drop in the marginal rate encourages Mrs. Jones to go back to work. With the two income earners, the Jones family income rises to $120,000. At the 10% rate, their tax rises to $12,000
Could this happen?
Tax Rate
Tax Revenues
0% 100%Revenue Maximizing Rate
Tax Revenues = (Tax Rate) (Tax Base)
The basic logic behind the Laffer Curve is that the tax base should be negatively related to the tax rate.
Are taxes too high or too low?
Annual Federal Receipts (Billions)
Year 0 Year 1 Year 2 Year 3 Year 4
Kennedy (1964) $116.8 $130.8 $148.8 $153.0 $186.9
Reagan (1981) $617.7 $600.5 $666.5 $734.0 $769.2
Bush (2001) $1,853.4 $1,782.5 $1,880.2 $2,153.8 $2,402.7
Tax Rate
Tax Revenues
0% 100%Revenue Maximizing Rate
History suggests that taxes are two high, but be careful…
Source: Congressional Budget Office
The Social Security Act was signed into law by President Roosevelt on August 14, 1935. In addition to several provisions for general welfare, the new Act created a social insurance program designed to pay retired workers age 65 or older a continuing income after retirement.
By late 1937, every American had a social security number
John David Sweeney of New Rochelle, NY had the first official Social Security account – his number was 055-09-0001
The lowest number belonged to Grace Owen of Concord, NH – her number was 001-01-0001The first benefits were
paid in 1940
Social Security numbers are assigned NOT in numerical order, but based on area – each state is assigned a set of area numbers.
Group numbers are done using an “odd – even” system
01 03 05 07 09
First Groups
10 12 14 … 98Second Groups
02 04 06 08 10 Third Groups
11 13 15 … 99Fourth Groups
For example, Indiana uses area numbers 303 - 317
Some Possible Sequences
305 – 52 - 5555 305 – 52 - 5556
305 – 52 - 9999 306 – 52 - 0001
NOT 305 - 54 - 0001
317 – 52 - 9999 303 – 54 - 0001
Old Age, Survivors, and Disabilities Insurance (OASDI) is the official name for social security (also called the “Payroll Tax”). Social Security is paid out of gross income – your contributions are matched by your employer
Medicare: 1.45%
Social Security: 6.2%
Maximum Taxable Income: $94,200 (Maximum Annual Tax = (.062)($94,200) = $5,840.40(Roughly $1,800/wk)
The first step to calculating your benefits is to calculate your average indexed monthly earnings (AIME)
For every year in which you had earnings, multiply that number (or the yearly maximum – whichever is bigger) by the index factor for that year – this converts your earnings to current dollars
Add up the 35 highest years and then divide by 420 (the number of months in 35 years) – this is your AIME
AIME Benefit Rate
$0 - $656 90%
$657 - $3,955 32%
$3,955 + 15%
You get full benefits if you retire at age 66. Your benefits are reduced by 25% if you retire at 62.
Example #1: Mr. Jones has an AIME of $750 (Roughly $9,000 per year)
AIME Benefit Rate
$0 - $656 90%
$657 - $750 32%
(.90)($656) = $590.40
(.32)($ 93) = $ 29.76
$620.16 (Retire at 66)
Example #2: Mr. Smith has an AIME of $5,000 (Roughly $60,000 per year)
AIME Benefit Rate
$0 - $656 90%
$657 - $3,955 32%
$3,955 - $5,000 15%
(.90)($656) = $590.40
(.32)($3,298) = $1,055.36
(.15)($1,045) = $156.75
$1,802.51 (Retire at 66)
Benefits are capped at $2,053/mo.
Individual Income Taxes: $1,082B
Corporate Income Taxes: $278B
Social Security Tax: $794B +
Total: $2.154T
The Federal Budget (Fiscal Year 2005)
+
Total: $2.472T
Other Mandatory Spending: $985B
Discretionary Spending: $968B
Social Security Payments: $519B
Social Security Surplus = $794B - $519B = $275B
Non-Social Security Deficit = $1,360B - $1953B = - $593B
Net Deficit = $318B
Since its creation, the social security system has run a surplus (social security payments are less than social security taxes). The government has used this surplus to fund other programs. This is done by selling Treasuries to the social security administration. The social security trust fund currently holds around $2T worth of US treasuries!
The social security system has relied on the fact that there are a lot more people currently working than currently collecting benefits. This won’t always be the case
1935: 9 workers for every 1 retiree
2005: 3.5 workers for every 1 retiree
2010: 1.5 workers for every 1 retiree
2014
2022
2034
Social security payments exceed social security taxes
Social security payments exceed social security taxes plus interest on trust fund
Trust fund exhausted – revenues sufficient to cover 70% of benefits
The payroll tax (social security tax) is a highly regressive tax.
Annual Income: $20,000
Payroll Tax Paid: $1240
Effective Rate: 6.2%
Annual Income: $100,000
Payroll Tax Paid: $5840
Effective Rate: 5.8%
Annual Income: $500,000
Payroll Tax Paid: $5840
Effective Rate: 1.1%
Effective Rate
Income
6.2%
3.8%
1.1%
$20,000 $150,00 $500,000
Consider Homer Simpson, safety inspector at the local nuclear power plant. Homer earns $7,000 per year (poor sap!). Lets assume that he starts working at 21 and retires at 66.
Under the social security system, total contributions for Homer would be 12.4% of $7,000, or $868 per year.
During retirement, Homer’s monthly social security benefit would be $525.
Suppose, instead, that the $868 in contributions were put into a 401K earning 4% per year.
At retirement, Homer’s 401K would have a balance of $105,053. The monthly interest earned would be $350
Consider Apu Nahasapeemapetilon, owner of the local Quickie Mart. Apu earns $15,000 per year. Lets assume that he starts working at 21 and retires at 66.
Under the social security system, total contributions for Apu would be 12.4% of $15,000, or $1860 per year.
During retirement, Homer’s monthly social security benefit would be $780.
Suppose, instead, that the $1860 in contributions were put into a 401K earning 4% per year.
At retirement, Homer’s 401K would have a balance of $225,114. The monthly interest earned would be $750
Consider Montgomery Burns, owner of the local nuclear power plant. Monty earns $150,000 per year. Lets assume that he starts working at 21 and retires at 66.
Under the social security system, total contributions for Monty would be 12.4% of $94,200, or $11,680 per year. (the maximum)
During retirement, Homer’s monthly social security benefit would be $2,053. (the maximum)
Suppose, instead, that the $11,680 in contributions were put into a 401K earning 4% per year.
At retirement, Homer’s 401K would have a balance of $1,413,613. The monthly interest earned would be $4,712
Over the years, social security tax rates have increased, while benefits have decreased. This has caused the implied rate of return in the system to decline over the years.
Year of Birth
Implied Return
10%
6%
2%
1905 1925 1960
Those that are just entering the system have an implied return of less than 1%!
Recently, there have been discussions about “privatizing” the social security system. Under a privatized system, individual payroll tax contributions would be placed in individual accounts to be invested – very much like a 401K plan.
Benefits
Higher return on investments will generate more retirement income
Increased saving should lower interest rates and promote more new capital formation
Individuals would be able to pass social security account balance to heirs
Social Security would be a self sustaining system, independent of population changes
Costs
Financial risk passed on to households
What do we do with lower income households?
Administrative costs would increase dramatically
Do we want the government to be a big player in financial markets?
How do we transition to the new system? (Current Social Security liabilities are around $25T!!)
The Minimum wage was first established in 1938 at $.25/hr
In 2002, 72 million US workers were paid on an hourly basis (60% of all workers)
2.2 Million reported hourly wages at or below $5.15/hr (3% of all workers). This number is down from 13% in 1979.
States with minimum wage rates higher than the Federal wage
States with no minimum wage law
States with minimum wage rates the same as the Federal wage
States with minimum wage rates lower than the Federal wage
States have the option of choosing a state/cities minimum (San Francisco has a minimum wage of $8.50) – if Federal and state wages differ, the larger of the two is applied
Minimum wage earners tend to be young. 50% are under 25 25% are between 16 and 19
Women are more likely to be on minimum wage 4% of women 2% of men
Part time workers are 4 times more likely to be on minimum wage (8% vs. 2%)
Most minimum wage workers have less than a high school diploma 2% of high school graduates <1% of College Graduates
63% have never been married By occupation, the largest proportion come from service industries
(roughly 2/3 of all minimum wage workers – mostly food service) By geographic region, the South had the highest proportion (4%).
The West has the lowest (2%)
What’s the profile of the average minimum wage worker?
The minimum wage is set in nominal terms. Therefore, periods of high inflation will erode the purchasing power of the minimum wage.
The minimum wage tends to average around 40% of the average hourly wage.
The important issue surrounding the minimum wage is: “What is the purchasing power of minimum wage workers?”
Minimum wage workers tend to be at or below the poverty threshold
Do we need a “living wage”? If so, what should it be?
The minimum wage is currently at $5.15 per hour. Assuming 40 hours per week and 50 weeks per year, this translates into an annual salary of $10,300 – essentially equal to the poverty threshold for a single person.
A living wage has often been defined as hourly wage that will raise a family of four with one income earner to 125% of the poverty threshold.
The poverty threshold for a family of four is currently $20,144.
This suggests a “living wage” equal to $12.59 per hour (a 244% increase from its current level.)
Does the Minimum Wage Cause Job Loss? Studies suggest that at the
aggregate level, any job loss due to minimum wage is negligible. One notable exception is
teenage employment. A 10% increase in the wage rate lowers employment by roughly 3%
Employers have several methods of absorbing minimum wage costs (lower benefits, higher prices, etc)
l
wsl
*l
dl
$4
Unemployment
Minimum Wage
l
wsl
dl
$4
Suppose that the current hourly wage is $4. At that wage, 100 hours are being supplied. Now, suppose that the government imposes a $2 per hour tax on labor – to be paid by employers.
10090
$3
$5
As a result, hours drop to 90, wages (before tax) fall to $3.
Taxes Collected = ($2)(90) = $180
If those tax revenues are redistributed back to those still working, the hourly “after tax” wage rises to $5
How is this different from simply increasing the minimum wage to $5?
The minimum wage, if you think about it as a tax, is a very strange tax.
The minimum wage taxes a rather small subset of employers in the US (those employers that pay the minimum wage)
Revenues “collected” by this tax are distributed to minimum wage workers (most of which are teenagers)
If our desire is to transfer income from one group to another, why don’t we use the system already in place? (Earned income tax credit, welfare, etc)
In 2005, the federal government spent $2.472T. IN the same year, the government raised $2.154T in taxes. The difference ($318B) was financed by issuing US Treasuries.
This represents about $1,000 per person in the US.
This, however, is only new debt. Total debt outstanding is a bit larger….
Roughly $30,000 per person!!!!
In 1993, Harry Figgie wrote a book entitled “Bankruptcy 1995”. In it, he argued that by 1995, interest payments on our debt would surpass total taxes collected. At that point:
The government would be forced to default on its obligations – this would cause financial markets to crumble
The government would be forced to raise taxes to stifling levels
The government would pay the debt by printing money – this would cause a hyperinflation ala Germany in the 1930s.
Could this actually happen?
0
1000
2000
3000
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5000
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7000
1946 1954 1962 1970 1978 1986 1994 2002
Total Public
Total Federal debt in the United States seems to be growing at an alarming pace!!
0
0.2
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1946 1954 1962 1970 1978 1986 1994 2002
Total Public
However, debt as a percentage of the overall economy has been (until recent years) falling.
Debt Growth = 5.5%/yr
GDP Growth = 6.5%/yr
0%
5%
10%
15%
20%
1946 1954 1962 1970 1978 1986 1994 2002
Alternatively, consider interest payments on the debt as a percentage of the overall federal budget. As a benchmark, the defense budget is currently around 18% of the total.
Defense Budget
Can an excessive debt burden hamper our economy’s ability to grow (and, hence affect our ability to repay it)?
i
i
Demand
Loans
Supply
The traditional argument is that government raises the demand for loans – this increases the interest rate and “crowds out” private investment
However, as long as the supply of loans (aka savings) can keep pace with the rising demand, interest rates don’t have to rise.
0.00
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4/1/53 4/1/61 4/1/69 4/1/77 4/1/85 4/1/93 4/1/01-500
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1 Year
5 Year
Deficit
The Large Deficits of the mid-eighties were associated with falling interest rates. In fact, the correlation between government borrowing and interest rates is near zero
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1946 1956 1966 1976 1986 1996
0%
20%
40%
60%
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100%
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Debt/GDP GDP Growth
GD
P G
row
thD
ebt (%
of G
DP
)Further, there doesn’t appear to be any obvious relationship between economic growth and the evolution of the government debt relative to GDP
Ownership of US Net Debt (millions)
Investor Total Percentage of Debt Percent of GDP
International Entities $1,225.5 35.5% 12.2%
Federal Reserve System $511.4 14.8% 5.1%
Pension Funds $390.9 11.4% 3.9%
Mutual Funds $325.4 9.4% 3.2%
State/Local Governments $246.9 7.2% 2.5%
Domestic Investors $224.4 6.5% 2.2%
US Savings Bonds $184.3 5.3% 1.8%
Insurance Companies $120.4 3.5% 1.2%
Total $3,447.9 100% 34.3%
It seems that savings is keeping pace with our borrowing….the real issue is the source of that savings….
Currently, the US is borrowing $2B PER DAY from the rest of the world. In fact, the US consumes 80% of total available funds worldwide!!
