Fiscal Sentiment and the Weak Recovery from the Great Recession

by on August 16, 2013 at 11:57 am in Uncategorized | Permalink

That is a new paper (pdf) by Finn Kydland and Carlos Zarazaga, the abstract is here:

The U.S. economy isn’t recovering from the deep Great Recession of 2008-2009 with the anticipated strength. A widespread conjecture is that this weakness can be traced to perceptions of an imminent switch to a higher taxes regime. The paper explores quantitatively this fiscal sentiment hypothesis. The main finding is that the hypothesis can account for a significant fraction of the decline in investment and labor input in the aftermath of the Great Recession, relative to their pre-recession trends. These results require, however, a qualification: The perceived higher taxes must fall almost exclusively on capital income.

In general I don’t buy it, mostly because I don’t think the higher taxes on capital income are coming that soon.  I see the higher risk premium from the crisis itself, the fracturing of the intangible capital behind credit relationships, slow underlying productivity growth, the labor-saving nature of recent innovation, and a growing sense of the dysfunctionality of U.S. government as the main culprits behind the slow recovery.  Still, the Kydland and Zarazaga paper brings us further down its stated path than I would have thought possible.

collin August 16, 2013 at 12:16 pm

How many times do we see that this comeback was because of x. Krugman in Jan. 2008 said that this recession was long and deep and the job growth would be slow. That is because the last two recessions showed the same thing in jobs and the definition of layoffs has changed the last thirty years.

1) It is productivity driven economy so the cost and time for a new worker to be successful is longer.

2) Look at the public and private payrolls this recession. Although it was long term necessary, Krugman’s Fifty Hoovers was correct. What has been slowing down jobs the last two years is state government hiring. Long term it might be “Only Obama and Republican governors could cut government payrolls.”

3) With so many goods moving towards services (with modest investment needs) and digit (where R&D is paid from company cash), investment borrowing is not as much needed. We don’t as many building, houses, railroads, etc.

4) There is long term demand issue as all functional, competitive societies have diminishing birth rates. This is now the great irony, that a country needs to have a lower birth rate (allowing for lower wages and more job flexibility) for high growth but creates a long term deflationary environment.

Collin Reid

mulp August 16, 2013 at 1:29 pm

Why not simply:

lower wages and shorter hours working means lower household income means lower consumption means lower economic growth?

The Fed is pumping cash into Wall Street to drive up security prices, buying debt from past labor and consumption, but not fund new labor.

Charles D August 16, 2013 at 4:38 pm

Why not? Because then you’re left to explain the lower wages and shorter hours. Collin provides quite a few possible explanations above that are much more helpful than “things are getting worse because they’re getting worse, and economics is nothing but a bunch of self-perpetuating cycles, fueled by ‘animal spirits’, that don’t need or have any structural cause/explanation.”

That’s why not.

Z August 16, 2013 at 1:17 pm

I share Tyler’s skepticism. Business activity can be depressed by expected changes in costs, but only when there is some degree of certainty. The management of a company is not going to freeze hiring just because they suspect their taxes will rise at some point in the future. They will delay hiring if they know for certain that costs will rise, but they are unsure of the degree. The ObamaCare cloud hanging over the labor market is a good example. Business knows some cost increase is coming so they wait until they know the details.

My own pet theory is that this recession is similar to the Long Depression. The hangover of technological capacity is keeping employment from recovering and that in turn is keeping GDP growth trapped in this narrow band.

mulp August 16, 2013 at 4:59 pm

Workers with less income (and no longer able to redistribute wealth from those with money to themselves by borrowing and using the Constitution to make it their own money by way of bankruptcy) is not reducing worker consumption and thus reducing demand for business goods and services, leading then to less need for labor?

Why isn’t there a connection between worker income and consumption?

After trying for a decade to put more money in worker pockets by borrowing from those with money at the Federal level, that still didn’t do much to increase worker incomes so the workers would drive demand for goods and services enough to create household income growth by higher wages and longer work hours.

And cutting taxes and then cutting wasteful government spending on infrastructure did not lead to the private sector spending more wisely than government on new bridges and new water and sewer systems and on reforesting burnt forests and preempting wildfires by cleaning up the built up tinder in the wildlands surrounding suburban housing. Thus cutting taxes only killed jobs, not create jobs. And resulted in further deterioration of public assets.

mulp August 16, 2013 at 1:18 pm

Yeah, right, this has absolutely nothing to do with the stagnant and declining wages of workers over the past three decades offset only by workers going deeper and deeper in debt over the past three decades, because workers are not the consumers who drive growth in the economy.

Nope, it is the threat and reality of high taxes on capital that is harming economic growth.

Why if taxes on capital were sure to cut, Mitt Romney would immediately up his consumption by buying:
10 iPhones per week
12 Big Macs a day
1 SUV per month

Of course, if he had to pay for his health care out of pocket, he would shop around and find the provider who would do his once a month colonoscopies for $100 instead of the government driven up price of $1800, and thus would get one colonoscopy per week. Or would the $100 price instead of $1800 out of pocket for the first one each year from his Bronze medical plan with $2000 deductible mean he would only get a colonoscopy once every five years.

Why don’t economists try to do a budget for real workers? Explain why the Atlantic got it wrong when reporting on the McD’s budget worksheet for its employees:
http://www.theatlantic.com/business/archive/2013/07/mcdonalds-literally-cannot-imagine-how-its-workers-would-survive-on-the-minimum-wage/277845/

Household incomes rose in the 80s primarily by the traditional marriage of a breadwinner and homemaker was destroyed by downward pressure on wages through destroying labor rights like employers having moral responsibility for workers and union organizing rights by marriages requiring two breadwinners to realize the American Dream.

In the 90s, the expansion was dependent on some households setting the standard through dual professional incomes and the traditional workers going into debt by increasing mortgage debt over time in a house instead of paying off the mortgage to become debt free.

In the 00s, the limits on the number of jobs in a household and the amount of debt were reached, and household consumption had to collapse, cutting demand, cutting labor required, and putting downward pressure on wages, putting downward pressure on household income, putting downward pressure on consumption.

So, what do ecomomists call for to create more growth and thus more jobs??

Lower wages which means lower household income, as if Mitt Romney getting twice as rich will result in Mitt Romney personally consuming more than twice as much.

Unless the expectation is Mitt Romney is going to look around Mass and decide he will spend his personal fortune fixing the many bridges he refused to hike taxes to fund repairs and are now in desperate need of higher cost repairs, or even replacement because they are too far gone…

Brian Donohue August 16, 2013 at 1:24 pm

I don’t see why “The perceived higher taxes must fall almost exclusively on capital income.”

I continue to hold a $250K liability on my balance sheet for taxes accrued but not paid. I recommend a typical family of four does the same. I dunno what taxes Uncle Sam’s gonna use to wangle this money outta me but, for now, my balance sheet is more leveraged than it would otherwise be, which I reflect in my investment decisions.

mulp August 16, 2013 at 5:04 pm

You think the typical family of four has over $1,000,000 in capital gains?

Or are you arguing that the deferred tax labor income of $1,000,000 is the typical retirement savings of families of four?

How can you reconcile that with the studies that same most people in their fifties have less that about $50,000 in assets?

Yancey Ward August 17, 2013 at 10:53 am

I have never seen anyone more unable to read perceptively than you, Mulp. You may as well have accused him of advocating people wear elephants on their heads.

Yancey Ward August 17, 2013 at 10:55 am

I have never seen anyone less able to read perceptively than you, Mulp. You may as well have accused him of advocating people wear elephants on their heads.

ThomasH August 16, 2013 at 6:12 pm

If more people felt this way, one would expect a massive increase in labor supply in order to build up assets to hedge against the risk. Big If.

stan August 16, 2013 at 1:37 pm

Obamacare, regulatory overkill, carbon tax fears, uncertainty over Dodd-Frank rules.

TMC August 16, 2013 at 3:11 pm

Bingo!

mulp August 16, 2013 at 5:07 pm

Why not wages, including your own, are too high?

Wouldn’t you having less income result in higher profits, and thus create wealth in security prices and that would result in the now richer rich eating twice as many Big Macs each day?

Max Planck August 16, 2013 at 7:36 pm

Polly want a cracker?

Go Kings, Go August 16, 2013 at 2:00 pm

In general I don’t buy it, mostly because I don’t think the higher taxes on capital income are coming that soon.

The author is talking about fiscal sentiment during the recovery, that is sentiment over the past 5 years. During the period covered by the paper, Federal tax rates on capital/dividends increased from 15% to 23.8% and on business profits from 35% to 43.4%. So what you think “is coming” shouldn’t matter in assessing this paper. I think.

Barkley Rosser August 16, 2013 at 2:00 pm

I agree Tyler, although I would not be as kind as you are to the authors. That one can cook up a DSGE model that assumes such a fiscal sentiment and then shows that it produces slow growth is a no-brainer. The question then is, is there any evidence of such a fiscal sentiment or any reason to take it seriously? The answer is simply an overwhelming no. Their only evidence is one quote from 2009 from Lucas, who admits that he is “speculating” and has no evidence, but suggests it could happen. Wow.

I think some other factors are more important than those listed by stan, but I suspect that all of those are more important than this one. The budget deficit is currently falling sharply, even if most of the public seems to be oblivious of this fact. Yes, there are projected increases further out, but the obvious candidate for a tax increase would be an increase in the income cap on fica, yeah, high income folks, but that is specifically a tax on wages and salarines and not capiital income.

This paperp is a pathetic joke.

Andrew` August 17, 2013 at 4:04 am

Already falling sharply? Is this another example of my Favorite “it isn’t a problem because look at all we did to fix it!” Fallacy?

Go Kings, Go! August 16, 2013 at 2:04 pm

I don’t buy it, mostly because I don’t think the higher taxes on capital income are coming that soon.

Federal capital gain/dividend rates increased from 15% to 23.8% and rates on business income from 35% to 43.8% during the period studied in this paper. Your criticism seems off.

Comments are broken August 16, 2013 at 2:05 pm

I don’t buy it, mostly because I don’t think the higher taxes on capital income are coming that soon.

Federal capital gain/dividend rates increased from 15% to 23.8% and rates on business income from 35% to 43.8% during the period studied in this paper. Your criticism seems off.

Phill August 16, 2013 at 2:09 pm

I’ve only skimmed the paper, and I’m hopelessly unqualified to talk about it, but:

The notion that people make short-to-medium term decisions based on being able to arbitrage long-term tax rates always struck me as absurd; are there strong methodological concerns with trying to approach this empirically, i.e. by interviewing people who invest?

In that light it’s really not obvious to me what building a model that responds to “fiscal sentimentalism” is supposed to show. Or is fiscal sentimentalism a more subtle form of behaviour people don’t consiously optimize for?

Phill August 16, 2013 at 2:10 pm

I’ve only skimmed the paper, and I’m hopelessly unqualified to talk about it, but:

The notion that people make short-to-medium term decisions based on being able to arbitrage long-term tax rates always struck me as absurd; are there strong methodological concerns with trying to approach this empirically, i.e. by interviewing people who invest?

In that light it’s really not obvious to me what building a model that responds to “fiscal sentimentalism” is supposed to show. Or is fiscal sentimentalism a more subtle form of behaviour people don’t consciously optimize for?

Bryan Willman August 16, 2013 at 2:12 pm

Taxes are already higher. There are credible arguments they will go higher yet. There are credible arguments they will be directed “where the money is” (e.g. at the relatively well off and corporations with deep pockets)
This is combined with a very complicated health care “thing” the true costs of which will not be known for some time.
All in an environment of limited demand.

So people (including me) will be prone to “get small” – don’t extend in any way, don’t take on any more risk, hunker down.

In the world of fear and greed, frear is still winning. Whether that’s about taxes, regulation, or demographics, doesn’t matter.

Joe Smith August 16, 2013 at 2:31 pm

If this effect is true then we should have seen companies “de-capitalizing” by spewing out dividends – we did not see that.

As an investor with over a million dollars sitting in cash and cash equivalents the two things that are holding me back from investing are:
1) a deep seated belief that the derivatives markets are a giant ponzi scheme and that as a result the financial statements of the major banks are essentially works of fiction; and
2) a belief that the Republican Party is insane.

celestus August 16, 2013 at 3:12 pm

“If this effect is true then we should have seen companies “de-capitalizing” by spewing out dividends – we did not see that.”

I’m not endorsing the paper, but what if you also count share repurchases as “de-capitalizing” ?

Joe Smith August 16, 2013 at 3:27 pm

I agree that share repurchases would count as “de-capitalizing” and we have seen some of that (just as we have seen some dividends) but we have not seen a great surge of buybacks.

mulp August 16, 2013 at 5:16 pm

But what would you do if you held Apple stock and they paid out all the cash on hand in dividends thank to zero taxes on bringing overseas income to the US and all dividend taxes being zero?

Would you use the cash to repair or replace a bridge that is in poor shape on your way home, or replace the roof and upgrade the HVAC on your kids school?

Should Apple spend its cash investing in bridges and school buildings for public use?

Andrew' August 17, 2013 at 4:30 am

The Democrats are the wackos in charge, who by the way have done nothing but increase liabilities in a balance-sheet recession, but we’ll set that aside.

Capital income is not the same as capital, right? What is taxed is income, Tyler Cowen’s wealth tax proposals notwithstanding. So, if you can reduce your expected “capital income” by increasing your capital (e.g. Amazon) then the reverse of your expectation could be observed.

Joe Smith August 17, 2013 at 6:56 pm

“The Democrats are the wackos in charge”

The Democrats are not the ones who are saying that defaulting on the debt or shutting down the government would be good ideas. It is the Republican Congressional majority who passed the Ryan budget and now cannot put together a proposal for the details of what they have passed into law. It was the Republicans who voted to increase subsidies to farmers.

B August 16, 2013 at 4:22 pm

I don’t think it’s the most likely explanation, but I like that they did this. It’s nice to see this line of thinking explored rigorously.

ThomasH August 16, 2013 at 5:29 pm

I’d say there has been an expectation of monetary policy failure to maintain NGDP growth.

Deepish Thinker August 16, 2013 at 5:44 pm

“slow underlying productivity growth, the labor-saving nature of recent innovation”

Impressive accomplishment to have both labor-saving innovation and low productivity growth.

Paul August 21, 2013 at 8:23 pm

I was thinking the same thing! I don’t know if there is anyway to square low productivity growth and labor-saving technology, but perhaps the inputs to production of technology come out to be just as costly as labor, and so no gain in total factor productivity is achieved?

derek August 17, 2013 at 1:08 am

A long recession like this, as the crash in 2008 is usually a failure on multiple levels. Yield in a low interest rate environment is tight, so with tax rates increasing on capital both direct taxation and regulatory cost increases (a tax with a different name) eats away at the returns. There are lots of other influences as well; the easiest path to money is to get latched on the flow of money from the Fed and Treasury, which does not create a vibrant economy based on innovation. The financial system is just plain useless; it would have been considerably smaller and smarter if reality had been allowed to run it’s course, but now it is a cost and burden on the rest of the economy. The usual fire sale prices on assets after a downturn didn’t materialize with the Fed desperately trying to prevent deflation, preventing the normal shedding of debt and the harsh discipline of reality that needs to be administered from time to time.

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