EFB338 Contemporary Application of Economic Theory

Semester 2, 2010

Matthew RobinsonPage

THE SHADOW ECONOMY (BENNO TORGLER).....................................................................................................3

1. TAX COMPLIANCE....................................................................................................................................................31.1. Introduction....................................................................................................................................................31.2. Theory of crime and punishment....................................................................................................................31.3. Extending the theory of crime to tax evasion.................................................................................................61.4. How to measure non-compliance (methodologies)........................................................................................91.5. Evidence - what determines tax compliance?..............................................................................................141.6. Conclusion....................................................................................................................................................15

2. CORRUPTION..........................................................................................................................................................162.1. Introduction..................................................................................................................................................162.2. Benefits of bribes..........................................................................................................................................162.3. Adverse consequences of corruption............................................................................................................162.4. Causes of corruption....................................................................................................................................162.5. Measurement................................................................................................................................................172.6. Case Study – A free press is bad news for corruption..................................................................................182.7. Case Study – Gender and Public Attitudes towards Corruption and Tax Evasion......................................202.8. Case Study - Winning isn’t everything: Corruption in Sumo Wrestling......................................................21

3. MONEY LAUNDERING............................................................................................................................................233.1. What is money laundering?..........................................................................................................................233.2. Data sets & measurement.............................................................................................................................233.3. How to do it?................................................................................................................................................243.4. Economic implications.................................................................................................................................253.5. Theoretical model.........................................................................................................................................253.6. Future study areas / policy...........................................................................................................................26

BUSINESS CYCLES AND MONETARY POLICY (STAN HURN).........................................................................27

4. BUSINESS CYCLES..................................................................................................................................................274.1. What is a business cycle?.............................................................................................................................274.2. Theory...........................................................................................................................................................27

5. MONETARY THEORY.............................................................................................................................................305.1. Introduction..................................................................................................................................................305.2. Traditional case for rules.............................................................................................................................305.3. Rational expectations case for rules............................................................................................................315.4. Modern case for rules...................................................................................................................................32

6. MONETARY PRACTICE...........................................................................................................................................336.1. Areas of agreement.......................................................................................................................................336.2. Bodies controlling monetary policy.............................................................................................................336.3. Setting the interest rate – the Taylor Rule....................................................................................................336.4. Dual mandate or price stability only?..........................................................................................................346.5. Explicit inflation targets?.............................................................................................................................356.6. How much transparency?.............................................................................................................................356.7. How to deal with asset price bubbles?.........................................................................................................35

HUMAN CAPITAL (DAVID JOHNSON)....................................................................................................................37

7. HUMAN CAPITAL ACCUMULATION.......................................................................................................................377.1. Private returns to schooling.........................................................................................................................377.2. External return.............................................................................................................................................377.3. School quality...............................................................................................................................................377.4. Peer effects...................................................................................................................................................38

8. IMMIGRATION........................................................................................................................................................408.1. Who decides to emigrate and where do they go?.........................................................................................408.2. How do immigrants fare in the labour market?...........................................................................................408.3. What affect does immigration have on native wages and employment opportunities?................................41

9. LABOUR MARKET POLICIES....................................................................................................................................43

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9.1. Types of labour market policies...................................................................................................................439.2. Types of unemployment and job search.......................................................................................................439.3. Active Labour Market Policies (ALMP).......................................................................................................449.4. Australia’ work for the dole.........................................................................................................................459.5. Other empirical findings..............................................................................................................................46

ECONOMIC GROWTH (JAY)......................................................................................................................................47

10. INTRODUCTION..................................................................................................................................................4711. NEOCLASSICAL / SOLOW MODEL......................................................................................................................47

11.1. Solow model.................................................................................................................................................4711.2. Mankiw, Romer and Weil (MRW) & criticism.............................................................................................4711.3. Overview of weakness..................................................................................................................................4811.4. Improvements to the model...........................................................................................................................48

12. EASTERLY & LEVINE’S 5 STYLISED FACTS.......................................................................................................49

EXAM PREPARATION.................................................................................................................................................51

13. EXAM FORMAT...........................................................................................ERROR! BOOKMARK NOT DEFINED.14. SAMPLE QUESTIONS FROM BLACKBOARD.........................................................................................................51

14.1. PART ONE...................................................................................................................................................5114.2. PART TWO...................................................................................................................................................5114.3. PART THREE...............................................................................................................................................5114.4. PART FOUR.................................................................................................................................................51

My Essay............................................................................................................................................................................52

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The Shadow Economy (Benno Torgler)

1. Tax compliance

1.1. Introduction

(a) Importance of taxesTaxes are considered to be what we pay for a civilised society.

Taxes are key to the operation of a civilisation.

Although it is supposed that noone likes paying tax, without it, there would be problems in public finance, law enforcement, organisational design, labour supply, etc.

(b) Why is tax evasion is bad?Tax evasion:

reduces tax collections, affecting the amount of tax compliant taxpayers receiver or the services that citizens receiver

creates resource misallocation as people change their behaviour to evade tax

requires government expenditure to detect and deter evasion

may alter income distributions unpredictably

create feelings of unfair treatment, or disrespect for the law

reduce the accuracy of macroeconomic statistics.

1.2. Theory of crime and punishment

(a) The basic modelThe economic theory of crime and punishment offers a predicted model of criminal behaviour.

The theory is based on a rational, amoral person – someone who carefully determines the means to achieve illegal ends, without restraint by guilt or internalised morality.

In the model, crimes and punishments are ranked by seriousness and severity, such that more serious crimes usually attract more severe penalties.

Under the theory, a person will engage in the crime when the benefits outweigh the publishment. There is perfect disgorgement where the offence exactly offsets the offender (represented by the 45-degree line), whereby a person will be indifferent.

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Figure 1 - Severity of punishment as a function of the seriousness of the offence

(b) Probabilistic extensionThe punishment of criminals is probabilistic because the offender may escape detention, apprehension or conviction. As a rational decision maker, the person will take this into account.

This is done by determining the expected value of the crime, which is:

E(R) = Benefit – (punishment x probability of being punished)

Figure 2 - Probabilistic approach

In Figure 2 above, committing the offence is not worthwhile, even for an amoral person.

However, where the expected return is positive (ie where the E(Punishment) is below the 45-degree line), the benefit of committing the crime exceeds the expected cost.

A rational person will maximise the seriousness of their offence such that they will commit the offence with a seriousness where marginal benefit = marginal expected costs (ie until they achieve X* in Figure 3).

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Figure 3 - When does crime pay?

(c) Aggregate crime (quantity)We can adjust the analysis slightly to focus on the quantity of crime.

We can say that as the expected punishment decreases, the quantity of crime increases (see Figure 4).

This is often described as the first law of deterrence. Laboratory experiments with rats have found this to hold.

If the supply of crime is elastic, policy makers can reduce crime significantly by moderate increases in expected punishment (Cf inelastic supply, where expected punishment will be a relatively minor factor).

Figure 4 - Aggregate crime

(d) Theories and concepts underlying crime theoryThe model of rational crime simplifies reality. Crime has a number of causes, and should usually be studied with multiple variable regression analysis.

Assumptions that underlie the economic theory are:

the criminal is informed – he or she knoes the costs, benefits and probabilities associated with crimes – transaction costs are not involved with obtaining this information

the person is risk neutral

all the criminal’s costs and benefits are monetary.

i) Diminished rationality

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Many crimes occur where the person has diminished rationality.

Two terms are relevant:

prudence: where the person gives reasonable weight to future events

imprudence: unreasonably little weight is given to future events, indicating a high discount rate.

This concept can be formalised to assume that a person’s discount rate is variable and unpredictable, but adheres to a predictable probability distribution (ie that in Figure 5).

As such, most of the time, a person has a moderate discount rate, ensuring that they act prudently.

However, from time to time, a person will have a high discount rate meaning that the benefits achieved from the offence now (ie t = 0), outweigh the future expected punishment in the future (ie t = 1).

Under this extension, a discount rate r* is assumed to be the tipping point at which the crime would be committed. Where the person is close to the tipping point, small changes in punishment can be highly influential in the decision. Conversely, where r is not close to r*, changes in expected punishment are not effective to change the outcome.

Age reduces the variance of g(r).

Increased variability of moods (also the effect of drugs and alcohol) can increase the probability of wrong-doing.

This implies that policy should be targeted at reducing the variability in moods (ie reducing the episodic use of alcohol and drugs).

Figure 5 - Tipping point for lapses of judgement

1.3. Extending the theory of crime to tax evasion

(a) Traditional theoryThe economic evaluation of tax compliance is based on the model of crime detailed at above.

Taxpayers will maximise the expected utility of the decision to evade tax, balancing the benefits of evasion against the risk of detection of punishment.

The variables are:

an individual’s fixed income: Y

the percentage of income declared: D

the tax rate on reported income: t

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the probability of getting auditied: p

the penalty rate on each dollar that the person was supposed to pay, but did not: f.

If the taxpayer is caught, their payoff is:

Payoff = Y – t D Y – f ( t (Y - DY))

Payoff = Income – tax paid – penalty on tax not paid

If the taxpayer gets away with evasion, their payoff is:

Payoff = Y – t D Y

As such, the expected value of the taxpayer’s evasion can be represented as:

E(V) = (1 - p) (y – t DY) + p(Y – t DY – f (t (Y – DY)

E(V) = (probability of no audit x payoff without audit) + (prob of audit + caught payoff)

An individual will seek to maximise their payoff. Because the only equation that is up to the individual is the amount to declare, we maximise for the DY. The maximised equation is:

p x f = t

In other words, the taxpayer will evade tax until the expected penalty equals the tax.

Empirical evidence suggests that people actually report more income than this model predicts. This implies that there is a high degree of voluntary compliance.

(b) Public good structure (extension)The fact that individuals receive the benefit of government expenditure has been shown to affect the compliance decision – the more responsible the government is in providing value, the higher the compliance.

Thus, a person’s compliance decision will be influenced by the amount of tax they pay, the benefit they receive and the probability of getting court:

E(V) = (Y – t YD) + m s (G + t YD) – p f (t (Y – YD))

where:

Y is the gross income

YD is declared income

t is the tax rate

m is the surplus multiplier

s is the individual’s share of the group tax fund

G are the taxes paid by all other group members

p is the probability of detection

g is the penalty rate on unpaid taxes.

Maximising the expected value equation, we find that a person will report all income if:

p f + m s ≥ 1

(c) Social norms (extension)The basic evasion model can be extended to account for social norms, or disappropriation associated with tax evasion:

E(V) = (1 - p) (y – t DY) + p(Y – t DY – f (t (Y – DY) – d (Y – DY)

where d is the disutility from evading tax, which is greater as the amount increases.

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When maximised, the formula is:

p f = t - d

(d) Limitations in modelsThe models are limited in the following ways:

audit selection is endogenous – the integration of the audit selection rule to include factors such as previous evasion is likely to lead to better results

evasion is considered to be a one period game – litratutre suggests that where there are voluntary public good contributions, contributions decline with each repition

previous experiences or wealth changes are ignored

it does not take into account social interactions (conditional cooperation) – ie if the government can affect the social norm of compliance through:

internal norms – how taxpayers judge their own compliance in light of individual feelings about what is proper, acceptable, or moral

external norms – how taxpayers feel to be treated by the government in areas such as the payment of taxes, receipt of government services, or the responsiveness of government decisions

there are numerous extensions that complicate the analysis and make clear-cut results hard to isolate

(e) Further theoriesFurther extensions / approaches to compliance include:

Bordignon (1993), who assumes that taxpayers compute whether there is a fair trade-off between the diminished private consumption and the government provision of public goods; if the terms differ from fair terms, the taxpayer will evade tax to even out the unfairness, subject to the risk of getting caught.

Erard and Feinstein (1994) incorporate shame and guilt directly into the taxpayer’s utility; they assert that guilt is felt for underreporting even if not caught and ashamed if caught; these are hard to work with as they are unobservable. There is the possibility of using nueroscientific tools to explore guild and compliance.

non-pecuniary or psychic cost increases as evasion increases, which may explain why people refuse to take an otherwise favourable evasion gamble.

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1.4. How to measure non-compliance (methodologies)Because of its nature, tax compliance is concealed, meaning that economists must be creative when attempting to measure compliance. As such, empirical evidence is relatively rare.

(a) Indicative data

i) Taxpayer Compliance Measurement Program (TCMP)

The Internal Revenue Service conducted intensive audits between 1982 and 1988 of between 45,000 and 55,000 US household.

The TCMP found that:

40% underpaid their taxes – about 25% underpaid by more than $1500

53% paid correctly

7% overpaid

approximately two-thrids (2/3) of taxpayers intended to pay their taxes correctly.

Problems with the data:

There is little information about other variables (such as socio-economic status or demographics) that can aid in an analysis

the information is purely based on the taxpayer’s report and the IRS examiner’s detection of evasion, which may not discover all evasion

it does not cover those who do not file

honest errors are identified

results suggest a higher audit rate leads to more compliance.

ii) Tax amnesty data

Tax amnesty data is a direct measure of non-compliance, but is dependant on taxpayers self-reporting evasion.

This method is flawed in the sense that only a fraction of those who evade tax will participate in a tax amnesty. Those who do participate may not be representative of the overall population.

(b) Indirect methodsTax compliance may be indirectly measured by:

looking at discrepancies between income and expenditures in budget surveys and in national accounts

the difference between official labour force pariticpation rates and estimates of true participation rates

look for traces of unreported income in monetary aggregates (ie the use of cash in the shadow economy.

The IRS estimates there was a tax gap of between $257 to $298 billion in 2001, indicating a non-compliance rate between 15.5 to 16.6%.

The tax gap in switzerland is estimated to be 23.5% of all income tax for the years 1970 to 1995.

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Problems include:

attributing measurement errors to unreported income;

attributing all discrepancies to undreported income

driven by assumptions.

(c) Surveys

i) Introduction

Surveys are designed to elicit taxpayer’s attitudes about their reporting (tax morale). These can be adapted to estimate non-compliance.

Surveys are amenable to collecting socio-economic and demographical information, which helps to examine and test theories on tax evasion.

Surveys can be helpful to compare countries, or compare changes over time.

The ability to access more sophisticated statistical techniques have made surveys a more popular mechanism to collect relevant information.

Problems with surveys include:

that participants self-report, leading to inaccurate information – this may be due to dishonesty or a fallible memory

the sample may not be representative of the population

tax compliance is a sensitive area, so those who do evade may not be willing to complete the survey, or may moderate their views.

framing effects – the topic / questions may create biases

overstating the degree of compliance

experimenter effect participants trying to please the organisers by giving the answer they “want”.

ii) Methodological techniques

Possible ways of eliciting information from participants indirectly include:

“Does your employer deduct your personal income tax from your monthly salary?” An answer of no may indicate tax evasion.

“Please indicate who pays your tax on personal income or your tax on small business.“ An answer of nobody may indicate tax evasion.

“According to you, how many of your compatriots do the following: Cheating on tax if they have the chance” (4= almost all, 1= almost none)?”

using tax morale as a proxy.

Lewis (1982) suggests asking respondents whether they evade tax point-blank – it would be worth a go.

iii) Examples

(A) Taxpayer Opinion Survey (USA 1987)

The Taxpayer Opinion Survey provides a broad set of taxpayers’ opinions on aspects of the tax system, including the IRS, tax evasion and cheating on taxes.

Questions include “Within the past five years or so, do you think you maight have overstated any deductions or expenses … even by a small amount?” and “Within the

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past five years or so, do you think you might have left some reportable income off your federal tax return – even just a minor amount?”, with answers being on a scale of 1 to 4 being “definitely have not” to “definitely have” respectively.

(B) Afrobarometer

Worded the question as: “We would like to remind you that your responses to this interview are confidential. Here is a list of actions ordinary people are taking in a political system. For each of these, please tell me whether you have engaged in this activity or not?”

For “Avoid paying income taxes”, the variables were coded as follows: Yes, often; Yes, a few times; Yes, once or twice: (0), No, but would do it if had the chance: (1), No, would never do this: (2)

(C) Latinobarometro

“Could you tell me if recently you have known someone or have heard someone you know comment about somebody who has: Managed to avoid paying all his tax” (1=yes, 0=no).

“On a scale of 1 to 10, where 1 means not at all justifiable and 10 means totally justifiable, how justifiable do you believe it is to: Manage to avoid paying all his tax?”

(D) World Values Sruvey

“Please tell me for each of the following statements whether you think it can always be justified, never be justified, or something in between: … Cheating on tax if you have the chance”. The question leads to a ten scale index of tax morale with the two extreme points “never justified” and “always justified”.

(E) Regression on perceived tax evasionWEIGHTED ORDERED PROBIT Coeff. z-Stat. Marg. Coeff. z-Stat. Marg.

Clustering

PERCEIVED TAX EVASION -0.186*** -18.110 -0.074 -0.186*** -4.710 -0.074

CONTROL VARIABLES (1) Demographic Factors AGE 30-39 0.099*** 3.890 0.039 0.099*** 2.650 0.039 AGE 40-49 0.216*** 7.970 0.085 0.216*** 5.220 0.085 AGE 50-59 0.298*** 10.150 0.116 0.298*** 6.180 0.116 AGE 60-69 0.318*** 8.630 0.124 0.318*** 4.860 0.124 AGE 70+ 0.446*** 10.340 0.171 0.446*** 5.740 0.171 WOMAN 0.123*** 7.800 0.049 0.123*** 6.020 0.049 EDUCATION -0.004** -2.530 -0.001 -0.004 -1.040 -0.001 (2) Marital Status WIDOWED -0.048 -1.590 -0.019 -0.048 -1.640 -0.019 DIVORCED -0.174*** -6.200 -0.069 -0.174*** -5.230 -0.069 SEPARATED -0.187*** -3.430 -0.075 -0.187*** -3.930 -0.075 NEVER MARRIED -0.084*** -3.740 -0.034 -0.084** -2.160 -0.034 (3)Employment Status PART TIME EMPLOYED -0.083*** -2.940 -0.033 -0.083** -2.250 -0.033 SELFEMPLOYED -0.106*** -3.290 -0.042 -0.106** -2.340 -0.042 UNEMPLOYED 0.131*** 4.320 0.052 0.131*** 2.900 0.052 AT HOME 0.019 0.640 0.008 0.019 0.370 0.008 STUDENT -0.055 -1.510 -0.022 -0.055 -1.130 -0.022 RETIRED -0.091*** -3.070 -0.036 -0.091** -2.240 -0.036 OTHER 0.083 1.500 0.033 0.083 1.390 0.033 (4) Religiosity CHURCH ATTENDANCE 0.041*** 13.590 0.016 0.041*** 3.630 0.016 (5) Culture/Regions WESTERN EUROPE 0.089*** 6.000 0.035 0.089 0.860 0.035 Number of observations 32610 32610 Prob > chi2 0.000 0.000

NB: -ve correlation means less compliance

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(d) Experimental economicsThe use of experimental economics has been increasing over the past 20 years generally.

i) Laboratory experiments

(A) Why use lab experiments?

The idea of lab data is that:

you can control naturally occurring processes, dealing with causality

internal validity – it is replicable by any other competent investigator

simplify – create the simpliest possible economic environment that allows you to address issues.

control all the variables you can

control focus variables – by controlling all other variables, you can test the effect of a particular variable

randomisation – randomise experiments so that weather, time of day, etc will not have an effect on a person’s behaviour.

(B) Problems with lab experiments

Problems with field experiments include:

external validity – the result from the lab experiment may not generalise well to the larger, ongoing outside the lab. Thus, insights may not be able to be extrapolated to the world beyond. The choices made in the experiment may be somewhat artificial – therefore the external validity of the experiment may be flawed

Human behaviour is subject to a plethora of influences

Subjects know they are being watched, and may alter their behaviour

Self selection – the people who participate in surveys may systematically differ form the population; for example, volunteers may be interested in the project or want to cooperate with the experimenter to seek social approval

The provision of financial incentives (and its quantum) may affect behaviour

Cannot replicate heavy penalties such as imprisonment

There may be a lack of social pressure, meaning that there is higher compliance than there would otherwise be

Experimenter effect – the experimenter may influence how participants see the experiment, so random allocation to a control group can control for this variable – there may be level effects, such that cooperation may be higher.

Often students are used for these experiments; problems could include a lack of experience and the possibility for a higher IQ than the population generally or may come from families with a higher income; age ranges may also be limited. (NB: evidence to suggest that students’ responses are not different from those of other subjects – indicating cognitive processes of students are not materially different from those of other people). A reason for using university students is purportedly their ability to easy understand abstract problems.

Replication is extremely important.

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(C) General application to tax compliance

The application of experimental economics circumvents the problem of people not reporting honestly and accurately as to their true behaviour.

The ability to control variables, allows researchers to identify both the relationship between variables and causality.

(D) Direct measurement – Benno’s method

A typical direct experiment may have the following characteristic:

subjects receive income each round and pay taxes on the reported income (if the experiement has a public good, all taxes finance the good)

tax administration is simulated by defining the probability of audit and the tax penalty on tax evasion

subjects are usually fully informed (but information may be used as a treatment variable) and stay together throughout the experiment

compare the results of treatment and control groups, by changing a variable such as audit probability, tax penalty, tax rate, fiscal redistribution, tax amnesties or voting on tax compliance

the number of rounds are pre-determined but unannounced.

(E) Indirect measurement – Business simulation

To avoid framing effects associated with simulating tax compliance, some experiments put participants in a business situation whereby they operate a small business and make a number of decisions including pricing, advertising, hiring personnel and tax compliance.

This has the advantage or experimental realism, but the downsides include that subjects may not be used to making such decisions and that the method lacks a certain amount of realism – ie people may not take it seriously.

ii) Field experiments

(A) Introduction

Field experiments allow researched to evoke real processes and behaviour, which allows a better test of the effects of variables in the real world. This allows to formulate practical policy responses.

An example of a field experiment would be for a tax authority to send out a letter about the importance of tax (or provide awards for compliance) to 50% of the population, while leaving the remaining 50% as a control, thereby testing the effect of the action on compliance.

The benefits from field studies include:

Allows social and economic interaction

No observable experimental effect as participants are unaware of having taken part in the experiment

More representative than laboratory experiments

Allows researchers to test specific policy alternatives, such as the effects of a higher perceived audity probability or the effects of moral suasion on tax compliance

The problems with field studies include:

Less control – may make causality harder to determine

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Need the cooperation of tax authorities

High transaction costs to deal with tax authority

Sensitivity of the tax filing data

Consumes a great deal of resources

Sometimes difficult to develop a treatment that can be hard to get approved by the tax authority – thus unorthodox treatments cannot be used.

Time can be a massive problem – the experiment has to be prepared before participants receive their tax forms, and it can be over a year until all tax forms are returned.

Field experiments are generally only used once – it’s hard to know the long term effects because there are not inter-temporal studies.

(B) Swiss Cantons - Letter setting out importance of tax

A letter was sent out to tax payers emphasising the importance of taxes. The experiment examined timeliness in submitting the tax return and timeliness of payment. [Check this:] The study found that there was no statistically significant improvement in the timeliness of payment (although the sign was as expectd), however there was an statistically significant improvement in the timeliness of filling.

1.5. Evidence - what determines tax compliance?

(a) Penalty ratesThere is a marginal improvement in compliance when penalties increase

(b) Audit ratesHigher random audit rates increase compliance.

It has been found that subjects substantially overestimate the probability of an audit.

(c) Tax ratesHigher tax rates lead to less compliance.

The Laffer Curve suggests there is an optimal tax rate for raising revenue, because after a certain level, the decreased compliance due to higher tax outweighs the additional revenue gained from compliant taxpayers.

(d) IncomeHigher income leads to higher reported income (but the lecture slides are unclear as to whether this amounts to compliance).

(e) Public good provisionWhere there is a public good financed by voluntary tax payments, this increases compliance. [I don’t know how that works, because it isn’t a tax if it’s not compulsorily levied by government]

(f) Tax complexity and uncertaintyGreater taxpayer uncertainty about true taxable income leads the taxpayer to report a higher taxable income

Greater uncertainty about the tax, penalty and audit rate raises compliance.

This may be because there is a greater perceived punishment.

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(g) Social norms and sociodemographic variablesElderly individuals are more compliant.

Women are more compliant than men.

Those who are self-employed are less compliant. This is often not significant, but in transition countries, the coefficient is mostly significantly negative.

There is a positive correlation be church attendance and tax compliance.

(h) InstitutionsHow tax revenues are used and the decision process (ie is it voted on, as in Switzerland) affects compliance.

Poor institutions may to less compliance.

Trust in the state leads to greater compliance.

Respectful treatment by tax authorities leads to greater compliance. Treating tax authorities as service departments leads to greater tax compliance.

Direct democracy and local autonomy are key factors – they set the rules between the state and taxpayers. More direct democracy and stronger local autonomy lead to significantly higher tax morale; it is posited that this is due to the fact that there is strengthened acceptance of government decisions and hence the willingness of the public to contribute towards it, as well as making taxpayers feel responsible for the decisions.

Fairness and transparency increase taxpayer’s propensity to contribute to public goods even if they do not benefit from them.

If people velieve that others are honest in paying taxes, this will increase their willingness to pay tax – this brings in the notion of reciprocity. It is posited that this represents the diminished social disapprobation associated with evasion.

(i) National prideA sense of group identification (ie national pride) encourages cooperative behaviour – this applies to tax compliance as well – national pride leads to greater tax compliance.

(j) Tax amnestiesTax amnesties generate a relatively small amount of additional revenue and only have small effects on post-amnesty compliance.

1.6. ConclusionThe plethora of factors that influence compliance makes a unified theory of tax compliance difficult to achieve.

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2. Corruption

2.1. IntroductionCorruption is defined as an illegal payment to a public agent with the goal of obtaining a benefit or avoiding a cost.

Because the state controls the distribution of valuable benefits and imposition of costs, there is an incentive for people to influence those who have discretionary power. The higher the economic rents associated with the benefits received / costs avoided, the more incentive a person has to evade regulations, and the higher the payments can be.

Corruption can undermine the legitimacy and effectiveness of government.

Inherent in this is the principle-agent problem.

2.2. Benefits of bribesBribes can be seen as economically efficient in the following ways:

They allow the market to clear, because the government has created a scarce benefit to individuals and firms using criteria other than willingness to pay

Public servants may not have any incentive to do their jobs properly, meaning there may be significant delays – bribes in the form of ‘speed money’ may provide such an incentive

Bribes lower the costs imposed on them by government in the form of taxes, customs duties and regulations.

2.3. Adverse consequences of corruptionIllegal business often purchase benefits corruptly from the state. This can go as far as dominating arms of government, or government departments.

A willingness to accept corruption reduces economic efficiency.

Well functioning governments often create incentives to motivate employees to be honest.

2.4. Causes of corruptionCorruption can be analysed by looking as corruption as a balancing act between expected benefits and costs.

Level of discretionary power and economic rents. This will be influenced by the sized and scope of the public sector.

Net utility function of corruption is a function of:

income from corruption

legitimate income (ie the wage of the gov officials)

strength of political institutions

Moral and political views of the society (including stigma)

Probability of being caught and punished – incl independence of judiciary.

Possibility of less corruption in democratic societies due to:

ability to vote government out of power

higher risk of exposure in democratic systems

Freedom of association and of the press, allows exposure of abuses

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increased ability for citizens to get informed and involved

Greater civic engagements = closer monitoring

oppositions parties have an incentive to discover and publicise corruption.

Higher economic development, characterised by increased education and literacy, will often lessen corruption.

Greater political stability will lengthen officials’ time horizons – ie they have a lower discount rate.

The greater the size of government and their control, the greater the opportunity for corruption because there are more benefits that may be given to business.

Large endowments of valuable raw materials may offer greater potential gain for offials in the allocation of such resources (mainly because these have large economic rents – think MRRT).

Corrupt agreements cannot be enforced – alternative mechanisms might be required – ie internal sanctions amongst ethnic or social groups.

Asymmetric information may allow corruption to persist

Influence of religion:

religion can foster cultural attitudes to social hierarchy

in hierarchical religions, challenges to office holders may be rarer than egalitarian cultures.

Religion may influence how individuals view loyalty to family v society generally

religion may be state-sponsored

The church may play a role in monitoring and denouncing abuses by state officials.

2.5. Measurement

(a) General methods

published sources – newspapers and internet

case studies (very rare)

Questionare (most common) – measure perceptions of corruption. Often aggregated into Micro-level serveys or country-specific corruption perception indices. Subjective perceptions of corruption can influence investment decisions, growth and behaviour of people.

There appears to be a high correlation between the various proxies for corruption.

(b) Perception based indicesSpecific indices:

Transparency International Corruption Perception Index – annual index that polls businessmen or local populations for each company. Often uses a number of different sources.

Quality of Governance Index – mean of 6 governance dimensions from a wide number of sources, using a large number of sources:

Voice and accountability – measures the political process, civil liberties and political rights

political stability and absence of violence – measures perceptions of the likelihood that the government will be destabilised or overthrown

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government effectiveness – inputs required for the government to be able to produce and implement good policies and deliver public goods

Regulator quality – focuses more on policies, such as incidence of market/unfriendly policies, perceptions of the burden of regulation

Rule of law

Control of corruption – measures the perceived corruption.

International Country Risk Guide – yearly data on corruption – assesses the corruption within the political sustem.

The first two indices are highly correlated (90%).

Potential problems / biases:

cultural background

does the survey consist of locals or expats – more objective or ignorant of culture?

do respondents compare to other countries?

do respondents consider the problem of corruption relative to other problems within the country?

are respondents evaluating it to a high ethical standard?

(c) Unique approaches

De Soto (1989) set up a business in Lima with the aim of complying with procedures and comply with the law. HE was asked for a bribe 10 times to speed up the process, and 2 of those times a bribe was necessay to continue. It took 10 months to set up the business.

Hundriks (1999) used anecdotal evidence to find that 94% of Tiwanese tax administrators had been bribed (76% in India).

Tracking entertainment and travel costs in China – although does include corrupt payments, it also includes legitimate expenses

measuring the amount of rice distributed b the amount actually received by households in an Indonesian anti-poverty program

Engineers’ estimated constructions costs and actual book costs (Indonesia)

Presence of politicians on boards.

Comparison of reported corruption and an objective measure based on Indonesian road-building program – basically did a survey of the amount charged and the amount it would have cost (went to local communities to find wages, got engineers to take core samples of the road to determine the amount of material used, etc).

2.6. Case Study – A free press is bad news for corruptionTesting whether a free press is an effective internal control on corruption.

Proposed to work against:

extortive corruption – government official had discretion vis-à-vis a service / permit (ie in Phillipoines a tax inspector would assess an unrealistically high payment on the taxpayer; it was hard to determine what the actual payment due was, and hard to appeal. Bribe of official to give correct figure.) A free press may identify the corruption and raise the costs for the bureaucrat – it has a platform of voicing complaints. However, an argument that media is only concerned about large events.

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collusive corruption – discretionary power in the application of rules (ie a customs inspector who has info about the value of a firm’s imports could agree to reduce the overall tariff liability). This is much more difficult to detect because both parties are happy, and have an interest to hide it. Journalists may have incentives to investigate such corruption.

Free entry into journalism makes it hard to form a cartel covering all journalists.

(a) ModelDependent variable is corruption measured by the International Country Risk Guide

Main independent variable is a measure of press freedom (with 0 being the best and 100 worst).

Controls:

Bureau – quality of the bureaucracy – degree of autonomy from political pressure, strength and expertise, and recruitment and training. Higher the better.

Rule – sound political instutions, a strong court systems – strength of institutions and rule of law.

GDP

HUMCAP – educational attainment

ETHNIC – degree of ethnolinguistic diversity as a proxy for cultural background.

Trade – openness to foreigh trade (should reduce monopolistic rents and corruption

Black – black market premium on FOREX

(b) ResultsThe study found that greater freedom of press was correlated with less corruption (negative coefficient). Results were statistically significant.

The study controlled for OECD / non-OECD differences and the effect was present in both cases.

Multiple indices of corruption and press freedom were used to ensure robustness – the effect still existed.

They used press freedom at the start of a 5 year period, and the other variables over the period, to try to establish causality.

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2.7. Case Study – Gender and Public Attitudes towards Corruption and Tax Evasion

(a) AimTo test whether women are more averse to engaging in corruption and tax evasion compared to men.

An analysis necessarily involves controlling for the opportunity to evade taxes. If there were identical opportunities, the null is that women would be just as corrupt as men.

Why are women proposed to be less corrupt:

Cognitive, emotional and behavioural factors due to different biological, psychological, and experiential realities

Different involvement of women and men in the workforce and government – women are less corrupt because they have less opportunity to be so.

It is interesting to note that:

Motor vehicle accident rates are higher for men

Men are more likely to be vivtims of accidental drowning or fire

Alcohol and drug abuse are more common among men than women.

Studies have found that women are generally more likely to contribute to public goods or common objectives (with some caveats).

Lower tax compliance among men.

(b) MethodUsed individual-level data from the World Values Survey and the European Values Survey for 8 western European countries from 1980 to 2000.

Used questions relating to the acceptability of corruption and tax evasion. Justifyability of tax evasion is highly correlated with the Transparency International Corruption Perception Index (0.358 – statistically significant) and Quality of Government rating (0.38 – statistically significant).

If the participation hypothesis is correct, then women should become more corrupt as they attain greater equality.

Using countries in the same region should reduce cross-cultural comparisons.

(c) ResultsWomen are less likely to engage in corruption and tax evasion, even after controlling for increased opportunities to become involved in such activities. Results show very little support for the opportunity theory.

Gender differences hold for each period and each country, despite the different opportunities for illicit activities for men and women at different times and in different countries.

The justifiability of tax evasion indicates an increase of the marginal effect of gender from 4.2 to 7.6%.

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2.8. Case Study - Winning isn’t everything: Corruption in Sumo Wrestling

(a) IntroductionIn sumo wrestling competitions, there are 15 rounds, and winning 8 rounds guarantees that you move up in the rankings, while only winning 7 guarantees you will move down in the rankings.

The average increase in rank for a win is about 3 positions, however there is a sharp non-linearity for a win that takes you from 7 to 8 – a movement of about 11 positions.Thus, there is a much larger incentive for a person to win if they have a 7-7 record compared to a 8-6 record.

Moving one spot in the rankings is usually worth $3000 a year.

The study examined the behaviour of participants.

(b) ResultsThe study found that the distribution of wins in each tornament was not normally distributed – there was a disproportionate quality of wrestlers who won exactly 8 matches (26%). This compared to 12.2% for exactly 7 wins. Under a normal distribution, these would be equal.

The authors also conducted a multivariate analysis using a probability model. The dependant variable was winning, and the independent variables “bubble” which was 1 if the wrestler was on the margin, -1 if the opponent was on the margin, and 0 if both or neither were on the margin. They also controlled for ranking differentials.

They found that for the last round, wrestlers on the threshold were 25% more likely to win than expected. The effect was present in rounds 12 – 14, but to a lesser extent, and were non-existent in round 11.

It is arguable that the effect can be attributed to increased effort.

However, in two periods media attention focussed on match fixing; in those situations the effect completely disappeared. This can be attributed to the deterrence model, such that an increased probability of getting caught will make it unprofitable to cheap.

If there is collusion, corruption may be positively related to the frequency in which the wrestlers expect to meet in the future – if they meet in the future, there is a chance for punishment for breaking an agreement.

Top ranking wrestlers may be less likely to be willing to throw matches because there is a large tournament prize. The study found that if the person is in contention for winning the tournament, the bubble benefit disappears.

There were very high win rates where wrestlers were in the same ‘stable’ of wrestlers, indicating that stables may collude between themselves to optimise utility.

The study also found that the first meeting between the 2 wrestlers after a win for the person on the bubble, the person who was on the bubble was 7% less likely to win. This indicated that they would allow the player to win next time (alternatively there could be monetary compensation).

Industry insiders made public the names of people who were corrupt and clean. When comparing matches factoring in these results:

Where there was corrupt-corrupt, or corrupt with an unknown person, excess winning proportion was between 18 and 27%

Where the person on the bubble was clean, against a corrupt wrestler, there was a negative, statistically significant relationship, indicating that they lost more.

Where it was clean vs clean, there was a positive, but not statistically significant benefit to being on the bubble – this may indicate effort.

Incentives are important.

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It is suggested that non-linearity in payoffs allow corruption to be more prevalent.

Increased media scrutiny helps to deal with corruption as it increases the expected punishment and probability of detection.

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3. Money Laundering

3.1. What is money laundering?‘Money Laundering’ is derived from the Mafia’s attempt to ‘launder’ illegal money via cash intensive washing salons in the 1930s.

It is defined as the process of transferring money between the official and the unofficial economy.

The IMG estimates that 2-5% of the world’s GDP stems from illicit sources and therefore must be laundered.

Money laundering is estimated to be worth approximately AUD2.8 billion. This is largely attributed to fraud / tax evasion, and then illicit drugs. This is typically invested in:

Further criminal activities – 21%

Professional services 7%

Real estate – 23%

Gambling - 16%

Luxury goods – 15%

Legitimate business – 12%

3.2. Data sets & measurementDifficult due to illegality and hidden nature.

Measurement approaches:

Currency demand approach – money laundering is usually done with cash payments, so its effect should be included in currency demand – the goal is to isolate it from legitimate currency demand

Measuring electricity consumption may be a way to calculate the size of the shadow economy, because it captures both illegal and legal economic activity

Amount of money confiscated / convictions

Direct subjective measurements – often uses surveys of experts – this can have disadvantages such as reliability of experts, small sample sizes, only measures perceptions (although there is a correlation between perceptions and observable behaviour). Note however the indices are highly correlated amongst themselves. Measures include:

Pevasiveness of money laundering through banks

Pervasiveness of money laundering through non-bank channels

Perception of no. of percentage of businesses that are unofficial / unregistered.

Perceptions of how much organised crime impacts on the cost of doing business.

Perception of tax evasion in the country.

Global Competitiveness Report

Executive opinion survey that avoids the limitations of official statistics

Expert opinions of business leaders and entrepreneurs – should represent the main sectors of the economy - CEOs and their staff members.

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International Country Risk Guide

law and order assessed separately – law sub-component assesses strength and impartiality of legal system – order sub-component is the popular observance of

Corruption – corruption within the legal system – actual or potential corruption in the form of excessive patronage, nepotism, job reservations, favour-for-favours, secret party funding & close ties between business and government.

Bureaucracy quality – strength and expertise to govern without drastic changes in policy or interruptions in government services.

Banks’ Cross-National Time-Series Data Archive – Conflict Index – covers assassinations, general strikes, guerrilla warfare, government crises, purges, riots and revolutions.

World development indicators – GDP per capita growth – affects the opportunities of money laundering and investment (r increases and c decreases).

Money laundering regulations index

Financial system regulation and disclosure – degree to which the authorities requires customers identification and record keeping, financial institutions rules, etc

Criminalisation – degree in which money laundering is considered a criminal offence; confiscation – degree in which the auythorieis take provisional measures and confiscations relating to money laundering.

Administrative authorities – depending on implementation and rrole of the regulatory and other administrative authorities regarding money laundering

International cooperation – international information exchange and international confiscation.

3.3. How to do it?Money laundering is a 3 stage process:

1. Placement – moving the funds from direct association with crime

Smurfing and structuring – breaking up a large deposit into smaller deposits to avoid currency transactions

Camoflage – getting higher amounts into the banking circuit by using flake passports and fake IDs

Currency smuggling – smuggling large amounts of cash over borders

Travelling cheques – purchasing travellers’ cheques with dirty money

Gambling - Converting cash into chips at the casino, and obtaining a cheque from the casino showing a legitimate transaction.

2. Layering – disguising the trail to foil pursuit

Correspondent banking: sender – bank of sender – SWIFT – Bank of receiver – Receiver

Bank cheques – transfer funds between persons or jurisdictions

Collective accounts – working with a person of reputable standing

Payable-through accounts – Accounts with the ability to conduct business in a second country as if the person had an account in that country

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Loan at low or no interest rate – allows to transfer large amounts of cash to other people, which will be paid back slowly.

Money exchange officers – corrupt exchange office / own the exchange burea. Paying taxes on profits gives it an air of legitimacy.

Money transfer offices – international money transfer agents are controlled to a different extent in different countries

Insurance market – arrange insurance policies on assets, and claims on the policies can be returned to the launderer.

Fictitious slaes and purchases – using legitimate organisations, explain exra income showing in the accounts

Fake invoicing – but note transfer pricing regulation.

3. Integration – making the money available to the criminal, with its origins hidden.

Capital market investments

Financial assets that can be purchased by the launder in order to invest the cash in reputable enterprise

Real estate acquisition – later sold as a legitimate source of cash

Catering industry – highly cash-intensive business

Gold & diamond market – can be purchased easily, with a high intrinsic value, and relatively compact.

Purchase of consumer goods to be shipped overseas, and then sold

Acquisition of luxury goods

Cash-intensive businesses – exchange businesses, restaurants, etc

3.4. Economic implicationsCan damage the financial system – its credibility and stability. It can corrupt confidence in the system.

It can distort investment patterns, as launderers do not seek the most effective investment.

The costs of money laundering reflect on the cost of illegal activity, so will have an impact on the size of the underground economy.

Money laundering has the potential to reduce the rate of growth.

3.5. Theoretical model

(a) For laundererBased on conventional criminal theoretical approaches, the expected utility of the activity can be written as:

E=U[(1-p)(R-C) + p(-C-F)]

= probability of getting away * (expected return [ R=(1+r)Y ] – cost of money laundering [C=cY] + probability of getting caught * (cost of money laundering and punishment)

There will be an optimal point, which is:

Y* = [m (1 - p) - c] / [2 p f]

This will mean that an increase in the punishment, fine rate or cost will reduce money laundering.

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(b) For governmentIt may be optimal for a country to allow a certain amount of money laundering because of flow-throughs to other sectors.

Countries that allow it are referred to as Lax Financial Regulation (“LFR”) countries. We analyse them from a ‘small country’ perspective.

The policy maker can allow money to be laundered (Y) between 0 and the demand for money laundering (W). The laundering does not directly provide utility to the policymaker, but may receiver and external benefit (B = mY). Where m > 0, there is a benefit to the policymaker, which may be due to the additional flow of black foreign capital, producing national revenues, increasing activity and associated follow throughs due to the multiplier effect.

These benefits are subject to costs, such as reductions in the country’s credibility and reputation (c), strengthening internal organised crime or terrorism (γ). Assuming criminal costs are more significant for the policy maker, the overall cost can be expressed as:

C = cY + γ2 Y

Foreign countries may impose a sanction (S) with a probability of (p). Assuming that the sanction is greater than Y, expressed as a multiple, and that different severity will be imposed, we can express the sanction as:

S = t Y2

The policymaker’s expected utility is therefore:

E(U) = u [(1 – p) (B – C) – p (C + S)]

Optimised, we find that:

Y* = [m (1- p) – c - γ2] / [2 t p]

3.6. Future study areas / policy Effect on globalisation

Increase in money laundering along with terrorism

Money laundering merely a symptom of illegal activity – so addressing the illegal activity may be more effective.

Loss in efficiency due to regulation of banks

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Business cycles and monetary policy (Stan Hurn)

4. Business cycles

4.1. What is a business cycle?3 key elements:

A business cycle occurs in economic activity

The cycle has phases of expansions and contractions

Cycles occur in many activities

The parts of the cycle are described:

Peak – top of the cycle

Recession – downward trend

Trough – bottom of the cycle

Recovery – upward trend

Economists distinguish between the classical cycle which is the level of the GDP series, whereby a recession is classified where there is negative growth, and the growth cycle where GDP is de-trended, whereby a recession is classified as below-trend growth.

During periods of sustained growth, there always appears to be murmurs that the business cycle is dead.

4.2. Theory

(a) KeynesianKeynes emphasises an autonomous reduction in investment generated by a lack of confidence, but did not set out how this would work.

A mechanism is one which consumption is smoothed and if investment is entirely driven by animal spirits, then national accounts identity shows that output would be a highly persistent process with animal spirits as the driving force.

(b) Multiplier-Accelerator ModelConsumption responds directly to current output, but investment is driven mainly by lagged output.

Ct = α + βYt

It = v (Yt-1 – Yt-2)

Yt = (v/(1-β)) (Yt-1 – Yt-2) + (α / (1+ β))

This is a 2nd order difference equation in Yt. The solution depends upon the precise values of the parameters, but cycles in Yt can easily result given an autonomous change in α.

(c) Monetarist Theory – Friedman - classicalMonetarists emphasised the role of the money stock in providing the impetus for the cycle, rather than shifts in investment. This is based on the following:

Money is neutral – classical dichotomy

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An unexpected growth of the money supply and the certeris paribus higher nominal prices and wages that go with it, make producers and wage earners overestimate the real prices and wages for their products and services. These overestimated prices and wages induce an increase in both production and the necessary labour supply, thereby creating an economic boom.

In the reverse situation, when money growth unexpectedly declines, the process too is reverse: real prices and wages are underestimated because of the certis paribus lower prices, and production and labour supply will be down. In this case there is a slump in economic activity.

Natural rate of employment / output assume A & K are fixed in the cobb-douglas equation labour market equilibrium determines the output equilibrium.

The effects on production and labour supply will be especially large if the perceived changes in real prices and wages are regarded as temporary, as this will give rise to an inter-temporal substitution of labour supply: in order to maximise leisure and income, producers and labourers will work more when prices and wages are perceived to be temporarily high and work less when they are perceived to be temporarily low. This emphasises the importance of expectations in the formation in the building of models of the macro-economy.

Problems with the basic Friedman-Lucas model:

There will only be prolonged periods of above and below average growth under the (unrealistic) assumption that people systematically err in overestimating prices in the boom and underestimating them in the bust. Taking inflation into account, there will be no periods of booms and recessions but only random deviations from trend growth.

Since changes in the inflation rate are usually quite moderate, it is not realistic to consider them to be the cause of major short term fluctuations in labour supply. Further, the ability to adjust working hours may be difficult.

(d) Real business cycle theoryRBC has its routes in microfoundations rather than macro analysis.

According to RBC theory, business cycles are real in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy given the structure of the economy.

RBC theory differs in these way from other theories of the business cycles in that it does not see recessions as a failure of the market to clear.

RBC theory sees recessions and periods of economic growth as the efficient response to exogenous changes in the real economic environment. This may be in the form of technological shocks (ie random fluctuations in technology).

Effectively, the rationale is that the behaviour is not ‘optimal’ in the sense that it is the best outcome regardless of the economic environment, but people make optimal decisions given the situation they face.

In a recession, consumption falls an leisure rises; in a boom, consumption rises and leisure falls.

Consumption-investment decision: People will smooth their income over their life (Permanent Income Hypothesis). As such, they will save in periods of high income (booms) and defer consumption to periods of low income.

Labour-leisure decision: It is assumed that when productivity is high people will substitute leisure for labour. There is also an income effect, whereby earning more will cause people to not need to work as much. However, the microeconomic literature indicates that the substitution effect dominates the income effect.

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The basic RBC model predicts that a positive temporary technology shock will result in rises above their long-term trend in output, consumption, investment and labour. The rise can be persistent because the additional investment means higher capital for future periods (this is referred to as internal propagation).

Criticisms with RBC include:

Do changes in unemployment reflect voluntary changes in labour?

Does the economy experience large, exogenous productivity shocks in the short run? This can be tested by plotting changes in output with the solow residual, which should represent TFP.

Is money really neutral in the short run?

Are wages and prices fully flexible in the short run? ie are prices sticky – this is the basis of New Keynesian theory.

(e) New Keynesian Business CycleNew Keynesians concede that in the long-run there is a natural level of output / labour, but argue that money is not neutral in the short-run.

They believe that deviations from equilibrium in the short-run are due to wage and price stickiness. This is posited to be due to:

Menu costs – changing prices is expensive, so firms will not change them if the cost of changing them is greater than the increased revenue. Sticky prices may be optimal for the firm even though they are undesirable for the company. This assumes monopsonistic competition, as the firm must have some control over its prices.

Coordination failure: In recessions, output is low, workers are unemployed and factories sit idle. Markets could clear if people were willing to cut their price or wages, but are unwilling to without knowing that others will do the same.

Staggered wages and prices: all wages and prices are not able to adjust simultaneously. Pricing decisions cause the price/wage level to adjust slowly. Further, as individuals and firms know wages / prices are slow for a while, so are unwilling to accept this.

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5. Monetary Theory

5.1. IntroductionModels that allow output to be suboptimal (ie those that do not require the market to clear) allow for economic policy to be used to improve welfare through the persistence of shocks and the amplitude of the cycle.

Policy is always subject to lags, such as:

inside lag – when it is recognised that policy should be applied to when it actually is

outside lag – time for the policy to have its effect.

Fiscal policy has a long inside lag, but short outside lag. Evidenced by yearly budgets.

Monetary policy is assumed to have a short inside lag, but a long outside lag. Monthly RBA meetings.

Because of the short inside lag, we assume that only monetary policy is used to stabilize output. This is also because fiscal policy has equitable & political considerations.

5.2. Traditional case for rulesA rule is a set of procedures which specifies what policy should be under any given set of circumstances.

A discretionary fiscal policy allows policymakers to re-optimise continuously.

The traditional rationale for a monetary rule is that it creates certainty.

(a) Simple exampleSuppose y is determined as follows:

yt = a0 yt-1 + b0 mt + b1 mt-1 + t

where the ay term is the persistence in output, the b & m terms are the effect of previousl and current monetary policy and t is a shock that is autoregressive distributing model, that is independently identically distributed (ie ah a mean of 0). Under such a model, we assume mt is set prior to observing t, so the goal is to minimise the variance of yt. The optimal variance minimising policy is:

If this is substituted back into the yt equation, yt equals the shock term, t. Such a policy removes all persistence in output. This may be seen as the outcome under discretionary policy, sincnce it is what would be chosen if there was re-optimisation each period.

(b) ProblemHowever, if b1 > b0, we have an unstable difference equation, where mt will be increasing in absolute value at an explosive rate. To deal with this, a ‘correction’ is applied to the previous period’s policy such that:

yt = a0 yt-1 + b0 mt + (b1 + v) mt-1 + t

where v is some constant. Under this situation, output is:

yt = v mt-1 + t

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Under this assumption of non-stationarity, which is in fact explosive, the growth rates of mt and

mt -mt-1, the variance of y is growing over time, such that the amplitude of the cycle is increasing merely due to slightly mis-estimating b1.

(c) Comparison with ruleIf mt =m-bar, the variance of output will be almost as small as for a discretionary policy, for sufficiently small values of a0, despite the central bank not knowing the structure of the output equation. Thus, having money constant may provide a much more stable policy than a discretionary policy where parameters are uncertain.

(d) Friedman’s arguments for rulesFriedman argues that less variable policy is superior in the presence of uncertainty. This is because if you don’t know the structure of the economy, then policy can destabilise. This also fitted with Friedman’s belief that there was no point in using monetary policy to affect output because in the long run the natural rate of unemployment prevailed.

5.3. Rational expectations case for rulesRational expectations is premised on the assumption that the level of prices will equal the expected level of prices given the information available, plus a error term that is iid.

Criticisms of rational expectations are focused on:

Even if the structure of the model is correctly perceived, computational difficulties will defeat the majority of individuals. Further, it is assumed that rational individuals do not make systematic errors, however in reality this may not be accurate. Also, it assumes the people have sufficient information.

the impossibility of discovering the correct model – there may be substantial disagreement about the structure of the underlying model. The Lucas critique states that the behaviour of rational individuals depends on the model adopted, and therefore changes in policy will have unknown consequences because it will change people’s behaviour – ie encode policy in behaviour.

challenging the incentive to acquire information. If the price incorporates all possible information about the thing, and therefore price = value, then there is no need to gather information. Rational individuals will merely get an average of published inflation predictions. The concern that there will be no incentive to gather information.

Under rational expectations theory, the output solution does not contain any monetary policy parameters, indicating that monetary policy is irrelevant.

This conforms with the Sargent & Wallace (1976) proposition that output only deviates randomly from its natural level. This is called the policy invariance proposition. Under this model (and rational expectations):

expected monetary policy cannot affect the level of economic activity in the model, since output does not depend on any of the parameters of the monetary policy rule.

Unexpected monetary policy does affect economic activity in a random way (because it is random, a rule would reduce the variance of the residual).

The use of ‘monetary surprises’ this leads on to the modern arguments for a rule.

5.4. Modern case for rulesThe modern case for rules is based on the notion that policy makers will have an incentive to fool people to obtain short-term advantages (namely increases in output) that result in lower welfare than would otherwise be the case (ie if policy-maker’s hands were tied).

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The government has an incentive to create unexpected inflation to put output above the natural rate. This creates a societal loss, because inflation is above the social optimal level. This is attributed to Barro and Gordon.

Rational agents will expect this, and therefore the economy will have an inflation bias. This is eliminated by the use of a rule because the government does not have the ability to affect policy. Thus, provided that the rule is credible, a rule will be superior.

It is suggested by having an independent central bank, which is more adverse to inflation than the rest of society, inflation will be lower when an independent central bank is delegated monetary policy.

New Zealand attempts to induce policy makers to be more inflation adverse than society by making their salaries tied to low inflation (often described as Walsh Contracts).

However, having a central bank be completely adverse to inflation would be detrimental if there are disturbances to aggregates supply, which would result in an increase in the variance of output.

Central banks have an incentive to pay a game where they minimise inflation for multiple periods, but then cash in their reputation to follow society’s preferences. They then re-build their credibility.

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6. Monetary practice

6.1. Areas of agreementEconomists generally agree that:

there is a unique medium run equilibrium rate of unemployment or output which is consistent with constant inflation. The long run will be determined by institutional and supply side factors. There is not necessarily a relationship between unemployment and inflation in the short run.

The speed of movement to equilibrium output/unemployment will depend on the decisions of policymakers, such that money is not neutral in the short run. Expected and unexpected policy can effect the short-run.

Monetary policy should be transparent (one way of doing this is to delegate the power to an independent policy maker).

An appropriate policy instrument is nominal interest rates. The way the economy adjusts to a new equilibrium with constant inflation is encapsulated in an interest rate rule.

6.2. Bodies controlling monetary policyThere is always a tension between what can be done in the short run and what should be done in the long run – this is the essential policy challenge.

{left out bits on different central banks}

Most central banks have a committee structure, which is favoured because:

A committee pools the disparate knowledge of its individual members such that it obtains a wide view

Members of a committee bring different decision making heuristics to a complex problem

Committees are less likely to adopt extreme or idiosyncratic positions – they will tend to inhabit the middle ground.

The decisions of a group are likely to be less volatile.

Price stability seems to be the primary objective, but there is often a dual mandate. Price stability often includes:

public announcement of medium-term target

institutional commitment to price stability

information inclusive strategy – such that the central bank shouldn’t disregard information so they have the flexibility to react to new information

increased transparency through public communication

increased accountability.

6.3. Setting the interest rate – the Taylor RuleThe Taylor rule is a 2 gap model (meaning it depends on the inflation and output gaps) that results in a simple linear reaction function.

The Taylor Rule states that the nominal interest rate should be:

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If output and inflation are at target levels, then the interest rate will be a. The real interest rate is a minus the target level of inflation.

Taylor suggested that = 1.5 and =0.5. These coefficients are much more contravertial than

the basic theory behind the taylor rule. However, there is agreement that . This is because you need to have sufficiently high interest rates that you are not seeing a decrease in the real interest rate.

(a) InflationThere is debate over the index that should be used. Some argue that the headline figure of CPI should be used as that reflects the price that needs to be paid by consumers, while others argue that underlying CPI should be used because that strips out changes in prices of volatile items (the argument is that there is no point using monetary policy to combat temporary price rises).

(b) TargetA target of 2% is popular, but there is little to suggest that an inflation rate of 3% is much more detrimental.

(c) Output gapMeasuring the output gap is difficult. It can only be measured historically, so economists often use trend data to extrapolate. This leads to difficulties if there are changes in potential output.

Further, even obtaining actual GDP figures is problematic given that they are only released quarterly.

(d) Equilibrium real interest rateThe equilibrium real interest rate may not be constant over time – as such when economies are growing quickly, the real interest rate is likely to be higher. Compare this to Japan, where the real interest rates are low to make borrowing for capital expenditures worthwhile.

(e) Does behaviour mimic the Taylor Rule?The Taylor rule was a reasonable estimator of monetary policy over the Volcker-Greenspan era (with an r-squared value of 0.75).

There were persistent deviations from the rule, which often constituted concern for the economy which was not represented in inflation and output data. For example, in late 1998 the fed cut rates despite a strong economy due to the Russian debt default and Asian Financial Crisis. Similarly, in 2002-03, the fed lowered rates below what the Taylor rule would predict (even for a sluggish economy and low inflation).

Central banks will want to smooth interest rates, so a lag term in the taylor rule may create more accurate results.

6.4. Dual mandate or price stability only?Some central banks (ECB and Bank of Enlgand) have a strict inflation targeting mandate, while others (the Fed and the RBA) have dual mandates that require them to consider inflation and growth.

Arguments against dual mandates:

they can undermine central bank credibility – if there is not confidence that the central bank is not completely focusing on low inflation, then inflation expectations are not likely to be anchored.

Monetary policy has limited influence on unemployment in the long run, so why make the central bank responsible for this?

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Arguments in favour of dual mandates:

Central bankers do care about GDP and unemployment, so why hide it?

Stabilising output will avoid big recessions and booms.

There may not be any internal inconsistency with inflation targeting and a dual mandate. Low inflation helps to boost economic growth over the long run by saving time and energy associated with dealing with high inflation: having to reset prices regularly, re-write contracts to deal with inflation, etc; facilitating long-run decision making, with consumers and businesses not having to worry about uncertainty about the future price level; enhancing the price signals and thus the functioning of the market.

6.5. Explicit inflation targets?Arguments in favour of a specific inflation target:

readily undertood and increases transparency

it shows the central bank is serious in its commitment to low inflation

it provides an explicit metric that the public can use to assess the central bank’s performance

and explixit target may help to anchor inflation targets.

Arguments against an explicit inflation target:

Which price index to use? The choice in indices can have large effects on the result. Maybe it would be advisable to look at the trends in a number of indices.

There is little indication that 3% inflation is significantly more harmful than 2% - the priority should be to ensure stable growth within moderate levels of inflation.

Reduced flexibility in the face of financial instability.

It is interesting to consider whether policymakers have an asymmetric response – ie are they more concerned with high inflation than low inflation.

6.6. How much transparency?Argument for transparency: If the bank has a serious commitment to low inflation, then letting the public see exactly how the process works may improve credibility.

Argument against transparency: Sometime economists disagree and these disagreements may not be well understood by the public.

Central vanks usually issue caregully-worded statements to provide guidance to financial markets. Lars Svennson argues that central banks should flag their intended future path. This would be far more precise than the lingo used currently, and may allow greater control over long-term rates. However, it could be argued that the public may see projections as commitments, and get confused, or see the central bank as indecisive.

6.7. How to deal with asset price bubbles?Asset bubbles are usually characterised by innovation that results in a surge in economic activity, but the innovation makes markets uncertain as to the extent of benefits arising from the innovation. This makes it hard to determine the existence, size or persistence of an asset bubble.

Policy maker may lean against an asset bubble by raising rates, effectively taking out insurance against the risk of an asset bubble.

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However, it is often argued that the cost of departing from optimal monetary policy is much more costly than the benefits achieved from leaning against the bubble. This is especially so given that bubbles have not proven to be particularly sensitive to the level of short-term interest rates.

Tools that are often used are:

the bully pulpit: public question the assumptions underlying the bubble and threaten policy to prevent the bubble.

Macroprudential tools: Regulatory & supervisory actions applied on a general basis – ie facilitating markets that allow people to short sell.

Monetary policy – tighten monetary policy to lean against the wind / bubble.

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Human capital (David Johnson)

7. Human Capital Accumulation{Most of the content about private and public returns to schooling are included in the essay at the end of the notes}

7.1. Private returns to schoolingThe return to schooling is often measured as a regression, represented by:

ln(W) = a + b S + other variables

To control for ability bias, studies have used:

identical twins

individuals born at the beginning and end of year

differences between people subject to different numbers of years of compulsory schooling.

7.2. External returnThere is a significant externality associated with additional schooling.

7.3. School qualityDifferences in school quality (teacher-pupil ratios, spending per-pupil, length of school year, educational qualifications of teachers) may be a major determinant of human capital.

(a) Teacher qualityResearchers agree that teacher quality does matter, however it is hard to define what a good teacher is.

Teacher incentive schemes are gaining popularity in Australia and elsewhere, but are met by strong opposition by teacher unions.

(b) Class sizesReducing class sizes is a popular policy from a government’s perspective because:

class sizes can be reduced without disturbing the overall structure of the school system

it is easy to implement and visible

teachers are usually supportive (may have their own interests in mind).

Smaller class sizes are said to improve achievement because it allow more time to be devoted to each student. Lazear (2001) provides a formal model which states that a person learns more in a smaller class because each student is disruptive for a certain percentage of the time, which means that the greater the number of students, the greater proportion of time they are going to be disruptive.

It is hard to measure the effect of class size, because assignment is usually not random:

If high achieving students are put into small, advanced classes, estimates will be upward biased

if low achieving students are allocated to small, remedial classes, estimates will be upward biased.

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allocation may be due to family attributes, such that wealthier families may move to districts with smaller class sizes.

Empirical evidence:

Hanushek (2003) argues that increases in school resources are an ineffective way to improve school quality – finds improvement is not consistent.

Krueger (2003) claims that Hanusek’s methodology is invalid.

Most studies fail to find a large, positive class size effect.

It is possible that sizes are close to optimal, such that further reductions have little marginal effect, or are so small they are difficult to detect in small samples.

The positive effects (if any) of class sizes are thought to be outweighed by the large cost.

(c) The STAR projectThe Student/Teacher Achievement Ratio (STAR) experiment started in 1985/86 an represents one of the biggest education experiments ever attempted. 11,600 students in 80 schools were involved in the experiment.

Kindergarten students and teachers were randomly assigned to small (13-17), regular (22-25) and regular + aide classes (22-25 plus a full time teachers’ aide). After 3rd grade, the experiment ended and all students were assigned back to regular classes. Students were to remain in their allocated class for the 4 years.

Problems:

students were not randomly assigned to schools, so there may still be school effects

10% of students switched between classes, primarily because of behaviour or parental complaints.

Only done over a few grades.

Students in the smaller class size performed better. However the effect was small.

The benefit did not increase over time.

7.4. Peer effects

(a) IntroductionBeing in a class of bright students may impact your education because the student gets:

more insights in class discussion.

Experiences less negative disruptions

Feels more pressure to compete

Better understands the importance of education (higher aspirations).

There are three sources of peer effects:

1 Endogenous interactions: the propensity of a student to behave in some way varies with the outcomes of the group – individual achievement varies with the average achievement of the students in the individual’s peer group.

2 Contextual interactions: propensity of a student to behave in some way varies with background characteristics of the group members 0 eg individual achievement varies with the socio-economic composition of the group.

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3 Correlated effects: students in the same group tend to behave similarly because they have similar individual characteristics or face similar institutional environments – eg individuals in the same school tend to achieve dimilarly because they are taught by the same teachers.

Distinguishing between these are important. For example, if there are endogenous interactions, increasing the academic performace will have positive effects on other students through feedback effects. However, no feedback effects will occur if there are only contextual interactions or correlated effects.

(b) Optimal compositionThe optimal composition of students will depend on whether students are complementary, or whether their learning can be classified as a negative cross-partial derivatives.

If students are complementary, the highest quality individuals should be matched. This effectively means that students should be segregated along income lines, as high SES students are deemed to be ‘higher quality’.

Under a simple model, a student’s human capital will depend on parental background (ie their expenditure on inputs) and that of the other student(s). The cross-partial derivatives imply that the backgrounds of two students are complementary, such that a good student is particularly benefited by having another kid from a good background. This would mean that it is socially efficient to segregate students according to parental background.

However, if there are negative cross-partial derivatives, students with a good background bring the rest of the class up, but help students with poor backgrounds more than they help students with good backgrounds. Thus, poor-background parents would want to have their kids in school with good-background students. Under this scenario, it is optimal to have schools with a mix of children.

Just because we observe segregation, does not necessarily mean background is complementary.

Theoretically, students from bad backgrounds should pay students from good backgrounds to go to their school, as they receive the highest benefit, but this is impractical.

(c) Empirical problemsIndividuals self-select into peer ground, which makes it difficult to separate selection effects from peer group effects.

If two people influence each other simultaneously, it is hard to know who influenced who. Thus, comparing individuals’ and peer outcomes will not provide a causal estimale.

It is hard to distinguish from contextual effects and endogenous effects.

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8. Immigration

8.1. Who decides to emigrate and where do they go?From a destination country’s perspective, it is superior to have immigrants with high productivity who adapt rapidly to conditions in the host country, thereby making a significant contribution to economic growth.

(a) Immigration investment decisionAn immigrant will migrate if they face a positive NPV outcome. Thus, they will immigrate if:

NPV = PV of destination - PV of staying - PV of costs of moving

Those with longer time horizons are more likely to immigrate.

Those who give greater weight to the welfare of their children have a higher propensity tomigrate.

(b) ROY modelThe Roy Model models whether the destination country is positively selecting (receiving good/highly skilled immigrants) or negatively selecting (getting bad/low-skilled immigrants) immigrants.

Assuming the model has earnings on the Y-axis and skills on the X-axis, we can plot the returns on skill to determine what types of immigrants will migrate. The two countries will intersect at point Sp.

Each country will have a different return to skill; a person will migrate if the return to skill in the destination country will benefit their skill set. As such, more highly skilled workers will prefer high returns to skill – steep gradients; lowly skilled workers will prefer low returns to skill (a more egalitarian society).

If the destination has a greater return to skill, workers with skills above Sp will migrate to the country, and workers in the destination country with skills below Sp may emigrate (depending on costs). For the source country, this constitutes a brain drain; they loose skilled workers. This constitutes positive selection for the destination country.

Conversely, if the destination has low returns to skill, the people who it benefits to migrate will be low-skilled migrants.

Different average income levels do not change whether a country is positively or negatively selecting migrants. It does however affect the size of the flow, and at what point (ie skill level) it becomes advantageous to migrate. For example:

if incomes in the country with the higher returns to skill fall, they will still positively select migrants, however Sp will be higher meaning that it is only beneficial for people with the very highest skill level to immigrate.

if incomes in the country with low returns to skill fall, they will still negatively select, but Sp will reduce, so there is less migration, which is only of the lowest skilled workers.

8.2. How do immigrants fare in the labour market?

(a) Economic Assimilation and Cohort effectsIt is generally accepted that over time immigrants will acquire human capital and skills that are necessary in the host country labour market (ie knowledge of language and culture, education, training and work experience).

Some evidence indicates that male migrants eventually overtake male natuves.

Empirical evidence suggests that there is a positive correlation between immigrant earnings and the number of years since immigration. However, caution must be exercised because there is the

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possibility of cohort effects. For example, if a study looks at waves of migrants entering the host country in 1960, 1980 and 2000, the cohort may have different attributes which make it difficult to estimate the benefits from assimilation; namely, if the cohorts have progressively less favourable attributes, the most recent (2000) immigrants will have much lower earnings, compared to the oldest (1960) immigrants – the earning differences could be purely attributed to assimilation, rather than cohort effects.

(b) Immigration selection processesBusiness Skills and Employer Nomination Scheme immigration have high pariticpation rates (82%) and low unemployment rates (3%). Other skill-based migrants (ie concessional family) have high participation rates, but their chance of being unemployed is greater.

Humanitarian immigrants have high levels of unemployment – ie 86% within 6 months and 56% within 18 months.

(c) Ethnic EnclavesEthnic enclaves are often said to hinder assimilation. However, such an argument is simplistic. Relevant factors include:

slower acquisition of host country skills: an ethnic enclave provides immigrants with less exposure to natives and therefore hinder their ability to obtain necessary skills and therefore jobs.

Network effects: living in enclaves can increase the opportunites for employment because the enclave disseminates valuable information (about jobs, etc), provides less discrimination than the rest of the labour market. This therefore improves outcomes.

Spatial mismatch: The enclave may be in a different place from employment opportunities, so may be disadvantages.

Human capital externalities: The unskilled migrants may benefit from being in a group that includes highly skilled members.

It is difficult to measure the effect of enclaves because selection is unlikely to be random, creating a bias in results – ie if only unskilled workers go into enclaves, then outcomes may be deemed negative.

Edin et al (2003) examins the effect of enclaves on assimilation in Sweden. They exploited a Swedish government policy to randomly place refugees where housing was available (refugees could leave, but 54% stayed in the same location for at least 8 years). The study found that the being in an enclave had a positive, but not statisitically significant benefit. They found that those with less than 10 years of education benefited from being in an enclave. They found that there was a statistically insignificant result that highly educated people suffered from being in an enclave.

8.3. What affect does immigration have on native wages and employment opportunities?

(a) Impact on wages – immigrants as substitutesPerfect market

The increased supply of labour will reduce the wage rate. However this will be more than off-set by the increased return to capital (producer surplus) – this benefits native firms.

Minimum wage

In the case of a minimum wage, the increased supply of capital does not reduce the wage, meaning that unemployment rises amongst the natives. Employers receive the same surplus regardless of whether there is immigration or not.

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Wage rigidity

In the case of wage rigidity, immigration increases the labour supply, which reduces the wage rate, but not sufficiently to let the market clear. This means that unemployment rises amongst natives. This results in employers gaining slightly. It is unclear whether the overall impact is positive or negative.

(b) Immigrants as complementsWhere immigrants are complements, they could raise the wages of native workers.

(c) Empirical evidenceEmpirically, there is very little evidence that immigration has caused significant reductions in native employment. Most find a 10% increase in the fraction of immigrants in the population reduces native wages by at most 1%. This even applies to natives who are close substitutes with native workers.

In the Mariel boat lift 125,000 Cubans were allowed to emigrate to Miami from Cuba. This increased Miami’s overall labour force by 7% and the low skilled labour force by 16%. The study of this event found a statistically insignificant reduction in unemployment over the relevant period. It is suggested that this result is due to:

native workers changing their location due to the immigration – native workers may leave the highly competitive labour markets, and/or there may be less domestic migration. For example, the Miami population grew at 1.4% compared to 3.4% for the rest of Florida.

Miami was extremely well set up to absorb Cuban immigrants – there were pre-existing Cuban employment and social networks, local industries had demand for their skills and the city had been accepting immigrants for decades.

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9. Labour market policies

9.1. Types of labour market policiesActive policies aim to increase employment and wages of unemployed people, and include job search assistance, training, employment subsidies and public sector job creation.

Passive policies aim to increase the material welfare of disadvantaged persons, and include unemployment and disability benefits.

9.2. Types of unemployment and job search

(a) Frictional unemploymentEven in a market equilibrium where labour supply equals labour demand, there will be frictional unemployment where people are between jobs. This is caused by the fact that employers and employees have to match, which takes some time.

(b) A model of job searchThe amount of frictional unemployment is determined by the speed of matching.

This process is modelled by job search theory.

Assumptions / foundations:

Employers require a minimum skill level K, and the wage associated with this skill level is W(K).

A job seeker has a skill level of K*; the maximum salary the person can achieve is W(K*).

Information is not perfect, so individuals do not know which firms require the skill set encompassed by K*.

Therefore, job seekers will apply to random firms, and will get offered the job where their hiring standard is ≤ K*.

However, the person will have a reservation WR, and they will not accept the job.

Under this model, the distribution (shown as a normal distribution) was centred around the the weighted average of the offers between WR and W(K*). The tails are shaded out because they pay too little or the required skill is too high.

The job-seeker’s reservation wage will respond to changes in the benefits and costs of search activities as well as their discount rate. The reservation rate will be in at the intersection of the marginal cost (upward sloping) and marginal revenue (downward sloping) curves. (dollars are on the y-axis and wage is on the x-axis).

Workers with high discount rates have less to gain from additional searches, so the marginal revenue curve shifts leftward, to a lower reservation wage.

Unemployment benefits reduce the marginal cost of the job-search, meaning that the marginal cost curve shifts-rightward, increasing the reservation wage. Because the reservation wage has increased, there are less jobs that are appropriate, meaning that the period of unemployment will be longer.

(c) Structural unemploymentStructural unemployment occurs when there is a mismatch between the skills possessed and the skills required in jobs that are created. This usually reflects underlying changes in the structure of the economy; it could also arise from job creation in different regions where old jobs are destroyed.

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This arises because the costs of adjustment are sufficiently high to prevent movements to the new industry.

9.3. Active Labour Market Policies (ALMP)

(a) Different typesJob broking services aim to help unemployed people locate jobs and improve their skills. It may involve access to job vacancy databases, assistance in writing a resume, interview training and placement into appropriate programs.

ALMP may come in the form of training, which is usually classroom training over a short period.

Subsidised employment programs may be in the form of wage subsidies or direct-job-creation. Wage subsidy schemes involve subsidies for a fixed period to firms to employ particular workers. Direct-job-creation programs are public programs that employ the unemployed, and usually involve doing community projects.

(b) How AMPLS may affect unemployment?ALMPs can be modelled using a labour demand curve and a labour supply curve (called the wage setting curve). They are plotted with the real wage on the y-axis and business employment on the x-axis.

i) Improve matching

ALMPs may improve matching by adjusting the skill mix of job seekers or enhancing the effectiveness of job searches.

Reduced vacancy-to-unemployment ratio reduces wage pressure, causing a downward shift in the wage-setting curve.

Vacancies are costly to employers, so the reduced vacancy-to-unemployment ratio causes an outward shift in labour demand.

This will tend to raise employment, with an uncertain overall effect on real wages.

ii) Productivity

ALMPs may increase labour force productivity through either training programs or on-the-job learning in the case of subsidised employment.

The productivity increase shifts the demand for jobs rightward, lifting employment and wages.

iii) Attachment to the labour force

Increase unemployed workers’ attachment to the labour force.

Stronger competition for jobs would shift the wage-setting curve down, raising employment and reducing wages.

iv) Subsidised employment

Subsidised employment may increase employment through a both a positive substitution effect and a scale effect from an overall reductyion in labour costs. This is represented by a rightward shift in

v) Lower disutility

If workers have a lower disutility of being unemployed (via extra income), they would demand higher wages during bargaining, shifting the wage setting curve leftward, reducing employment.

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(c) Deadweight losses and displacement and substitution effectsSubsidised employment programs are sometimes criticised because of:

deadweight loss – a proportion of the people would have been employed anyway

substitution effect – a proportion of the people will take the place of other people who would have been employed in the absence of the subsidy.

displacement effect – other employers may shed labour if they don’t qualify for the subsidy to retain competitivemenss.

An OECD review of Australia’s JobStart scheme estimated the deadweight loss as between 67 and 79%.

Thus, wage subsidy and job-creation programs are generally considered to be high cost, low benefit. But it comes down to a political decision as to whether the redistribution of opportunities to a particular group are worth it.

(d) Lock-in effectsThere is always a risk that people will reduce job search during the program.

(e) Evaluation of ALMPsIt is difficult to analyse the effect of ALMPs because of two-way causality – ALMPs may increase employment, but the prevalence of ALMPs may increase during periods of high unemployment.

Therefore, most evaluations are microeconomic. Effectively, researchers seek to measure the difference in labour market outcomes of participants and non-participants.

This is often difficult because of selection bias – ie people are likely to positively self-select into ALMPs, resulting in an upward bias. Further, administrators will often select the best candidates because of rewards for successful outcomes.

Data from social experiments where you have a treatment and control group will often have high internal validity, but low external validity.

To counteract selection bias, researchers use a process of matching – they use criteria that attempt to capture all observed and unobserved variables to match a person in the control group with one in the treatment group. However, problems can arise here due to the curse of dimensionality, whereby the more criteria that are used, the harder it is to match people. An alternative method is to use a participation probability /propensity score.

9.4. Australia’ work for the doleParticipation in work for the dole may have two effects:

participation directly affects individuals’ likelihood of employment

referral to work for the dole cause people to exit welfare payments when they would be required to begin – governments hope this effect is minor.

The empirical study matched a treatment and control group by a number of factors that resulted in people being able to be classified in one of 3,369,000 cells. It was possible to match 802 work for the dole participants to control group individuals. The weighted average of cell differenes is taken as the overall average effect of work for the dole participation.

Figures showed that more than a third of participants were in employment or education 3 months after completion.

It did seem to have a positive effect on receipt of welfare payments.

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9.5. Other empirical findingsJob broking:

appears to improve labour market outcomes

main effect seems to be increased job search intensity

most effective where do not distrort the type of job search and where labour demand conditions are most favourable

Training:

effectiveness depends on ability to deliver skills that are in demand – if there is a poor match, the lock-in effect is likely to dominate.

Effect of training is more evident over time

Subsidised employment:

usually leads to negative general equilibrium effects, with high costs

least skilled individuals derive the most from these programs, probably because it gives them the ability to acquire work skills.

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Economic growth (Jay)

10. Introduction{not examinable}

11. Neoclassical / Solow model

11.1. Solow model

(a) The steady stateAssumptions:

Positive but diminishing returns to capital and labour

Contstant returns to scale

Exogenous investment rate

Exogenous population growth

Exogenous rate of technological progress.

The model predicts that an economy will move to a steady state, such that:

sy* = (n + g + d) k*

Amount of income saved = capital/effective labour x (population growth + technological growth + depreciation)

At steady state, there is no movement from this equilibrium, unless one of these factors change.

(b) Transition dynamicsIf the capital stock per unit of effective labour (k) is less than the steady state capital stock (k*), savings/investment exceeds the depreciation term (n + g + d), meaning the growth in k > 0.

Conversely, if k > k*, then the depreciation term will erode the existing capital stock meaning the growth of k < 0.

The rate of growth will be greater the further away k is from k*.

(c) Conditional & absolute convergenceThe Solow model does not predict that there will be absolute convergence – ie it does not expet that countries will end up with uniform GDP per capita.

However, it predicts that conditional on a country having the same parameters (ie population growth, technology, capital and labour), poorer countries will grow faster to catch up to their steady state.

This implies that the coefficient for the output gap will be negative in any regression.

Convergence appears to hold for OECD countries, however non-OECD countries do not appear to exhibit convergence.

11.2. Mankiw, Romer and Weil (MRW) & criticism

(a) Steady state, effected by k* and depreciation?According to the Solow model, the steady state (y* & k*) will increase with savings and decrease with depreciation.

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They find that:

Coefficients have expected sign and are statistically significant.

59% of cross-country variances in GDP per worker can be explained by the steady state variables

The magnitude of coefficients are too large – ie α = 0.6, implying that 60% of income goes to capital.

(b) Speed of convergenceThe Solow model predicts that the economy will converge to its steady state, with growth falling as income rises.

MRW state that the Solow model predicts a convergence rate of 4%. However Barro and Sala-i-Martin estimate the speed of convergence to be approximately 2%. This is only half the rate predicted by the Solow model.

11.3. Overview of weaknessIt appears although the Solow model is internally valid, but may not be externally valid. The predictions do not match the quantitative observations, namely:

Capital share is too high (near 60%)

The rate of convergence is about 2%, which is half what is predicted by the model

Observed interest rate differentials and international capital flows much lower than model predictions.

11.4. Improvements to the modelTo cure these problems, it may be possible to:

Include a human capital accumulation term into the model.

Incorporate spill-over effects from capital investment – capital investment is posited to generate positive externalities for related industries.

(a) Augmented Solow model – human capital accumulationHuman capital is assumed to accumulate in a similar way to physical capital, so it can be modelled similarly. The production function can be stated as: Yt = Kt

α Htβ (AtLt)1-α-β , α + β < 1

In the same way that capital accumulates, human capital accumulation is:

Ht = SH Yt - dHt

where:

Ht is the stock of human capital

SH is the saving / investment in education

d is the depreciation of human capital.

MRW estimate that α = 1/3 and β= 1/3. They use this re recalculate the speed of convergence and find that it results in a speed of convergence of 2% which is much closer to empiric results. They find that this augmented model captures 80% of country differences at steady states.

However, the Solow model explains the level difference better than the growth difference. The method of MRW is criticised for not taking into account initial technology levels, and because it is not as accurate for OECD countries because there are little variation in steady state variables.

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12. Easterly & Levine’s 5 stylised facts

12.1. TFP is responsible for growthTotal factor productivity can be interpreted in a number of different ways, including externalities in factor accumulation, adoption of lower costs of production and technological spill-overs. From a regression point of view, TFP is basically the residual.

(a) Growth accountingGrowth can be broken down into its individual components pursuant to the cobb-douglas (or other) production function.

Empirical evidence has suggested that capital accumulation has accounted for a relatively small proportion of growth (12 – 25%), while TFP has accounted for over 50% of growth.

Evidence suggests TFP is larger for countries that are growing faster.

Incorporating human capital does not affect this.

The problem with growth accounting is that it does not imply causality, nor does it test the statistical significance of output growth and capital growth.

(b) Variance-decomposition approachThe variance-decomposition approach attempts to measure the relative importance of variables by determining how much the variance in the independent variables effect variance in output.

Results seem to indicate that the variance in output is attributable to TFP more than 60% of the time; cf capital which is not often above 25%.

(c) Level accounting{don’t know what the thing to take out of this is}

12.2. Divergence in per capital income over timeGrowth rates of ‘rich’ countries have not slowed over the past century – this implies that there is something else driving growth. Meanwhile, some poor countries have grown slowly, if at all. This appears to contradict the idea of convergence (but only in its absolute form).

12.3. Factor accumulation is persistent, but growth is notEconomic activity is characterised by booms and crashes, but this is not evidenced in factor accumulation. Conversely, TFP growth is not persistent.

Evidence suggests policy differences are more persistent than growth differences across countries. This may indicate that changes in policy may only have a temporary effect on a country’s growth rate, until they reach the technological frontier. It is is possible that growth miracles were caused by good policies, and growth disasters by poor policies.

Factor accumulation is persistent. This may be because schooling may respond to an expected policy over a future working life, and physical capital will also have a relatively long term life. Conversely, TFP is more subject to current policy because the private returns are shorter-lived (subject to IP laws).

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12.4. Economic activity is highly concentratedEconomic activity is concentrated. EL suggests that if there was no differences in TFP, factors would spread out evenly. However, the fact that this does not happen may be due to technology and externalities.

12.5. National policies care closely associated with long term economic growth

Economists disagree as to whether national policies are strongly linked with growth.

Openness to trade and financial development have been strongly related with growth.

EL show country growth rates are correlated with country policy variables, even after controlling for endogeneity (reverse causality) by using lagged variables (but lagged variables can still suffer from causality problems because it may influence future expectations).

The data showing greater growth may just be exhibiting temporary responses to policy.

Thus, policy may affect output levels, but may not influence growth rates beyond an initial movement to a higher level.

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Exam preparation

13. Sample questions from blackboard

13.1. PART ONEA PhD student is interested to explore whether state efficiency has an impact on tax compliance.

a) Discuss in detail what research methods the PhD student could use to investigate this question.

b) What are the advantage and shortcomings of the suggested methods to answer this research question?

c) The PhD student wonders whether it is possible to develop a theoretical model that allows to explore the impact of state efficiency on tax compliance. Please develop such a model.

13.2. PART TWOShould monetary policy be conducted in terms of rules rather than discretion? Discuss.

13.3. PART THREEa) Females attending single sex schools perform better academically than females attending coeducational schools. With reference to the economics peer effect literature, discuss possible explanations for this result.

b) Discuss how ethnic enclaves can affect the economic assimilation of immigrants.

13.4. PART FOURa) Policy changes in the Solow-Swan model have no long run growth effect. Elaborate.

b) Why do economies exhibit sustained growth in the Solow-Swan model?

c) According to Easterly and Levine (2001), what is the principal determinant of long run growth? Briefly comment on two loopholes in their argument.

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My EssayIntroduction

The positive impacts that education has on the individual and economy are unquestioned. Consequently, economic, social and political considerations necessitate a close analysis of whether higher education is equally accessible to all Australian citizens. Australian evidence suggests that low socio-economic status (“SES”) students are half as likely to participate in higher education than their medium and high SES counterparts (“SES Inequality”) (James, 2002). Given this inequality, eliminating SES Inequality to ensure an egalitarian and productive society, constitutes a unique policy challenge for the Australian Government.

This essay establishes the existence of SES Inequality in Australia’s tertiary sector and why the problem must be combated. It then briefly sets out policies that finance students’ university attendance. The paper proceeds to a critical analysis of full tuition-fee scholarships, having regard to its likely success in reducing SES Inequality. Finally, the authors consider alternative policies.

Australia’s education system and low SES disadvantage

More than one million people are currently undertaking study at one of Australia’s higher education institutions, with more than 650,000 of these receiving government assistance towards their education (Department of Education, Employment and Workplace Relations, 2008). Despite 25% of the Australian population being low SES, over the preceding two decades low SES students have consistently only made up 15% of the student cohort (James, 2002; Department of Education, Employment and Workplace Relations, 2009). This indicates significant educational disadvantage for low SES individuals.

SES Inequality is a legitimate ground for government intervention due to the economic and social externalities generated by education. Higher education is a key factor in human capital accumulation and is strongly tied to a nation’s economic growth (Jones, 2008). There is also strong evidence linking education to increasing civil citizenship, reduced crime and increased social mobility (McTaggart, Findlay, & Parkin, 2007).

Furthermore, there are a number of other private and public returns to higher education including, inter alia, superior health, welfare, self esteem, parenting skills and social tolerance (Murray, 2009). Importantly, recent studies have found that the positive externalities associated with education are greatest in the case of disadvantaged groups (including low SES), through increased social cohesion and resilience (Murray, 2009). Therefore, it is clear that equal access to higher education must be a high priority for policymakers.

SES Inequality has persisted in Australia despite the introduction of the first income contingent loan system, the Higher Education Contribution Scheme (“HECS”), now the Higher Education Loan Program (“HELP”) (Le & Miller, 2005). HECS-HELP is a sophisticated universal student financing system, whereby the Government subsidies the tuition costs of students and imposes a student contribution in the form of a contingent liability extracted through the tax system (Chapman & Ryan, 2005). The student repays the debt once his or her income is above the prescribed threshold. This means the risk is shared between the taxpayer and student. The success of HECS-HELP spurred the United Kingdom and New Zealand, among others, to adopt income contingent loan schemes (Chapman & Ryan, 2005).

Moreover, the existence of Youth Allowance and Austudy (“Income Support”) is important, because it provides means-tested fortnightly payments to university students. Both Income Support and HECS-HELP are seen to be essential to internalising the externalities generated by higher education, and reducing credit constraints.

Australia’s policy settings provide a base level of income while at university that reduces the quantum of forgone earnings, while deferring the tuition fees until individuals are benefiting from tertiary education. These policies are incorporated into the model of university attendance below.

Will scholarships reduce SES Inequality?

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Why do people educate themselves?

An individual’s income is predicted to increase by 7% for each year of higher education (Jones, 2008; Perna, 2005). However, this does not dictate that a person will pursue tertiary education. People are assumed to treat education as a net present value (“NPV”) investment decision, whereby a person will educate themselves where the marginal benefits exceeds marginal costs, adjusted for their discount rate. The stylised model in Figure 1 can be adapted to take into account the HECS-HELP and Income Support available to low SES students in Australia (see Figure 2). This framework informs the remainder of the essay.

Figure 1: The costs and benefits of tertiary education over a lifetime

Figure 2: The costs and benefits of education for Australian low SES students

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The scholarship program considered

The essay assumes that the tuition scholarship program (“Scholarship Program”):

is only available to low SES individuals;

requires potential students to apply;

is awarded on the basis of SES and academic ability;

pays all fees levied by the university;

does not provide further financial assistance.

Will a Scholarship Program reduce SES Inequality?

Scholarship Programs are posited to reduce SES Inequality the funding eliminates credit constraints - an inability to finance the costs of education – or turns higher education into a positive NPV investment. To examine the effectiveness and efficiency of a Scholarship program, this part examines whether it would mitigate credit constraints or change marginal investment decisions, and whether SES Inequality is in fact caused by a credit constraint.

Firstly, the Scholarship Program reduces the cost of repaying HECS-HELP later in life, but ignorers the immediate costs of higher education. Although this increases the NPV of the investment decision (although the extent may be minor depending on the student’s discount rate), it does not reduce the present costs of tertiary education, meaning that it does not alleviate credit constraints. Chapman and Ryan (2005) find that the introduction of HECS did not deter low SES students from attending university; this indicates that the removal of a HECS-HELP debt through a Scholarship Program is unlikely to eliminate credit constraints, nor see students’ education decisions change from negative to positive NPV investments.

The foregoing analysis fails to consider the concept of eligibility. Even if university attendance represents a positive NPV investment decision, poor prior academic achievement may preclude a student from admission to university. Cardack and Ryan (2009) find that after controlling for academic achievement, low socio-economic individuals are not under-represented in tertiary education. This finding appears robust, with similar results exhibited internationally (Galindo-Rueda, Marcenaro-Gutierrez and Vignoles, 2004), despite some evidence of small credit constraints in the UK and US (Dearden, McGranahan, & Sianesi, 2004; Carneiro & Heckman, 2002). Cardak and Ryan (2009) interpret their results to indicate that low SES students are not in fact credit constrained, rather that their prior academic performance is responsible for their non-attendance at university.

Therefore, the Scholarship Program is unlikely to reduce SES Inequality due to the ineligibility of many low SES individuals and the possibility that the scholarships will not materially affect students’ investment decisions or alleviate the credit constraints (if any) experienced by students.

Alternative policies to equalise access to tertiary education

This section canvasses alternative policies aimed at reducing SES Inequality.

If, contrary to Cardack and Ryan (2009), a portion of students are in fact credit constrained, a program that reduces the upfront costs of attending university is likely to have a greater impact. This could either be delivered through greater Income Support, or extending income contingent loans to living expenses (Bradley et al, 2008). This approach recognises that low SES students may incorporate higher discount rates into their investment decision due to, inter alia:

an up-bringing that does not emphasise the benefits of education, leading to a short-term focus; and

reliance by a student’s family on his or her income, making immediate foregone earnings more valuable (Bradley et al 2008, 47).

However, practicalities preclude these policies being effectively targeted at marginal (Bradley et al, 2008). Thus, providing support to offset the initial costs of education is unlikely to be a cost

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effective solution to SES Inequality due to its prohibitive cost and the small or non-existent influence of credit constraints.

Cardak and Ryan (2009) find that ineligibility for university is correlated with a student’s SES. Consequently, addressing the poor prior academic achievement of low SES students is a vital policy consideration. The effects of low SES on education achievement are seen by Grade 9 (Cardak & Ryan, 2009), and may be evident as early as pre-school and primary school (Chowdry et al 2010). Early interventions that:

involve quality early learning education;

are ongoing;

are staffed by highly qualified individuals

are of high intensity; and

involve parents;

are posited to substantially improve non-cognitive skills that are essential to enabling students to become eligible for university, counteracting the disadvantage suffered by low SES students (Knudsen et al, 2006; Heckman, 2000). This is consistent with neurobiological evidence (Knudsen et al, 2006) and the notion that learning begets learning (Heckman, 2000).

Further, structural changes to early, primary and secondary education is suggested as a cost effective method of decreasing SES Inequality. Changes may include, increased transparency in the public education system, introducing performance pay for teachers and increasing competition between schools (Heckman, 2000). However, programs to reduce class sizes are unlikely to return sufficient benefits to justify the substantial costs involved (Heckman, 2000). Other possible policy responses include outreach programs between schools and universities, as well as communicating of the benefits of education to low SES students and their families (Bradley et al, 2008; Milbourne & Bajada, 2008).

Finally, it is naïve to rule out non-institutional factors as a contributor to the problem. The family unit, and their attitudes towards education, can have an important impact on students’ educational development, aspirations and preferences (Heckman, 2000). Therefore, fostering an aspiration to attend university and reducing perceived barriers to entry into university are further policy objective that should be pursued to reduce SES Inequality (Dearden, McGranahan, & Sianesi, 2004).

Conclusion

It is clear that the alleviation of SES Inequality is a policy challenge, the resolution of which would return significant positive externalities for Australia. However, the challenge cannot be solved by implementing policies at the point of entry to university through tuition scholarships; if a small credit constraint exists in Australia, it is unlikely to be solved by a Scholarship Program. Instead, a holistic approach to education must be adopted, with a focus on the formative years of low SES students’ education, promoting an aspiration to attend university and reducing perceived inequalities.

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