Transcript INSTITUTIONAL ECONOMICS AND ECONOMICS OF THE …

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In financial markets, participants trade
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securities (shares, bonds, etc),
money (credit, loans),
foreign exchange,
insurance,
commodities (goods without qualitative differentiation)
derivatives . i.e. contracts between two parties concerning
some underlying assets (the most common underlying assets
include commodities, stocks, bonds and currencies). These
contracts specify conditions (dates, values, definitions of the
the parties' contractual obligations) under which payments
are to be made between the parties. The most common
derivatives are options).
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The main types of financial markets cover:
 Money Market
 Capital Market (Primary and Secondary)
 Insurance Market
 Derivatives Market
 Forex Market
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Financial institutions (intermediates) –
banks, investment funds, insurance
companies, stock exchanges, brokers, etc.
Financial transactions (Flow of money)
Financial risks
Disclosure of Information
Scope of market participants
Level of Debts
The toughest regulation form - licences
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Supervisors of national financial (money and
capital) markets – Central banks
Supervisors of national securities markets –
Securities and Exchange Commissions (SEC)
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EU and international regulatory bodies:
EU Commission, European central bank (ECB),
European Securities Committee (ESC),
Committee of European Securities Regulators
(CESR), Basel Committee on Banking Supervision
(comercial banks), Bank for International
Settlements (National central banks)
 Central banks - regulate banks on the
basis of Basel Accords (Basel II and Basel
III Directives)
 Securities and exchange commissions use the Markets in Financial Instruments
Directive (MiFID) framework
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Issued by the Basel Committee on Banking
Supervision
The purpose is to create an international
standard that banking regulators can use
when creating regulations about how much
capital banks need to put aside to guard
against financial and operational risks that
banks face
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The greater risk to which the bank is
exposed, the greater the amount of capital
the bank needs to hold
Ensure that capital allocation is more risk
sensitive
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was developed in response to the
deficiencies in financial regulation revealed
by the financial crisis.
These standards were recently endorsed by
the largest industrialized and developing
countries. They are being implemented
since January 1, 2013
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The aim is to reduce the probability of bank
failures by improving banks’ loss absorption
possibilities.
Basel III strengthens bank capital
requirement and introduces new regulatory
requirements on bank liquidity.
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The Markets in Financial Instruments Directive
(MiFID) goal is to
 complete the process of creating a single EU
market for investment services
 respond to changes and innovations which have
occurred in securities markets
 protect investors by making markets deeper,
more competitive and more robust against fraud
and abuse
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MiFID is the cornerstone of the European
Commission's Financial Services Action Plan
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Firms covered by MiFID are authorised and
regulated in their "home state" (the country in
which they have their registered office whereas
formerly, a service was regulated by the member
state in which the service took place).
Once a firm has been authorised, it can use the
MiFID passport to provide services to customers in
other EU member states.
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MiFID has requirements relating to the
information that needs to be captured when
accepting client orders, ensuring that a firm
is acting in a client's best interests and as to
how orders from different clients may be
aggregated.
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MiFID requires firms to categorise clients as
"eligible counterparties", professional clients or
retail clients (these have increasing levels of
protection).
Clear procedures must be in place to categorise
clients and assess their suitability for each type of
investment product.
That said, the appropriateness of any investment
advice or suggested financial transaction must be
verified before being given.
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MiFID requires firms to publish the price,
volume and time of all trades in listed shares,
even if executed outside of a regulated
market, unless certain requirements are met
to allow for deferred publication.
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MiFID requires that firms take all reasonable
steps to obtain the best possible result in the
execution of an order for a client.
The best possible result is not limited to
execution price but also includes cost, speed,
likelihood of execution and likelihood of
settlement and any other factors deemed
relevant.
 Socially desirable goods and services
 Protecting individual rights and privacy
 Regulation to benefit special groups
 Conservation of resources
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Social regulation concerns with
the conditions under which goods and
services are produced (working conditions,
health and safety standards, production
processes firms are allowed to use etc.)
the quality of goods and services (e.g.
product attributes)
the side effects of production on society.
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Social regulation has increased substantially
in the last three decades regardless of the
deregulation initiatives
 Rules that govern expected behavior
 Standards that serve as benchmarks
 Sanctions for non-compliance
 Administrative apparatus that enforces rules and
administers sanctions (enforcement systems)
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Establishing safety standards for toys.
Meat inspections.
Restrictions on smoking in public places.
Control of pollution emitted by firms’ production
processes.
Gasoline lead standards.
Fuel economy standards.
Product labeling standards.
The minimum wage.
Requirement for hardhats in construction areas.
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Economic tools - taxes and subsidies
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Information disclosure
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Direct regulation -Standard setting
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Licensing
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Inspection
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The regulatory (compliance) costs may
outweigh the social benefits derived from
the regulation.
Regulations are sometimes poorly written
and ambiguous.
Regulatory burdens can become
unbearable for small firms.
Better („smart“) regulation is needed.
Direct Costs:
◦ Costs of regulating (agencies, enforcement,...)
◦ Paid by Taxpayers
Indirect Costs:
◦ Costs of compliance
◦ Paid by customers/shareholders
Induced Costs:
◦ Non monetary costs (innovation, investment…)
◦ Paid by society in general
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Regulation has helped to:
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Improve the quality of goods
Clean the environment
Reduce industrial accidents
Improve the position of minorities
Prevent corruption etc.
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Demand for reform arises from regulatory
shortcomings.
Some regulations conflict with others, some are
poorly implemented, some impose directives
better developed by private enterprises, and some
fail to achieve the objective for which they were
originally created.
 A statement of the need for the proposed
action
 An examination of alternative approaches
 An evaluation of the benefits and costs
of the proposed action and the main
alternatives identified by the analysis
Economic Theory of Public Sector
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Economic theory of public choice
 The Economics of Taxation,
Redistribution and Government
Spending
The economic theory of public choice is concerned
with the provision of public goods
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In economics, the term public good refers to goods
that are not supplied by private companies
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The reason for this is that these goods are nonexcludable
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means it is not possible to exclude individuals
from the good's consumption.
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Non-excludability may cause problems for the
production of such goods
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Consumers can take advantage of public goods without
contributing sufficiently to their creation. This is called
the free rider problem
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Non-excludability leads to market failure: since
no private organisation can get all the benefits of a
public good it has produced, there will be
insufficient incentives to produce it voluntarily.
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public administration
security, defense and law enforcement (including
property rights enforcement),
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parts of economic infrastructure
environmental
goods,
information goods, such as software development,
authorship, and invention etc.
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Public Spirit
If enough people do not think like free-riders, the
private and voluntary provision of public goods may be
successful
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Public spirit may be encouraged by tradition and social
norms involving concepts such as nationalism and
patriotism
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Coasian solution
Potential beneficiaries of a public good band together and
pool their resources based on their willingness to pay to
create the public good.
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Provision: the transaction costs between potential
beneficiaries of a public good are sufficiently low, and it is
therefore easy for beneficiaries to find each other and pool
their money based on the public good's value to them.
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Legal exclusion
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solution, which has evolved for information
goods, is to create intellectual property laws, such as
copyright or patents, covering the public goods.
The downside of these laws is that they imply private
monopoly: the patent rights given to pharmaceutical
companies encourage them to lobby for the extension of
patent rights in a form of „rent seeking“.
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General solution to the problem is for governments to
impose taxation to fund the production of public goods.
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The difficulty is to determine how much funding should
be allocated to different public goods, and how the costs
should be split.
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Government provision
If private provision of public goods will not work, then
the obvious solution is making their provision/financing
involuntary.
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Subsidies
 A government
may subsidize production of a public
good in the private sector. Unlike government provision,
subsidies may result in some form of competitive market.
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alliance between political insiders and the
businesses receiving subsidies can be limited with secret
bidding for the subsidies or application of the subsidies
following clear general principles.
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Goods that the government feels that people will
underconsume and which therefore outght to be
subsidised or provided free
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Consumption of public/merit goods is thought to
generate positive externality effects
Regardless of the method of providing public/merit
goods, the efficient level of such provision should be
subjected to economic (cost-benefit) analysis.
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Public choice theory describes how political decisionmaking may result in policy that conflicts with the
overall desires of the general public.
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In other words, the theory aims to apply economic
analysis to the political decision-making process in
order to reveal possible systematic trends towards
inefficient government policies.
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example, many „special interest projects“
(promoted by „special interest groups“) are not in the
interest of the general public, however, it makes sense
for politicians to support these projects since they can
benefit from them.
Public choice theory attempts to look at
governments from the perspective of the bureaucrats
and politicians who compose them
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makes the assumption that they act in a selfinterested way for the purpose of maximizing their
own economic benefits (e.g. their personal wealth).
One of the basic claims of public choice theory is
that good government policies are an
underprovided public good, because of the
rational ignorance of the voters.
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Each voter is faced with a tiny probability
that his vote will change the result of the elections,
while gathering information necessary for a wellinformed voting decision requires substantial effort.
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Therefore,
the rational decision for each voter is to be
generally ignorant of politics and perhaps even abstain
from voting.
On the other hand, there are many interest groups
with strong incentives for lobbying the government
to implement specific inefficient policies that would
benefit them at the expense of the general public.
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One that generates substantial personal benefits
for a small number of subjects while imposing
diffused, small individual cost on a large number of
other persons
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total costs dispersed on a large number of people
are usualy higher than the total benefits
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The costs of such policy dispersed over all citizens
are often unnoticeable to each individual.
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On the other hand, the benefits are shared by
a small special-interest group with a strong incentive
to perpetuate the policy by further lobbying.
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Therefore, there is also an incentive for the
interest groups to try and influence policy in order
to ensure that the policy gets enacted which
favours them („rent-seeking“).
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For example, lobbying by the agricultural industry
might result in subsidis for the production of agricultural
goods, either directly or by protectionist measures.
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In public choice theory, such scenarios of
inefficient government policies are
referred to as government failure
Actions by individuals and interest groups
designed to (permanently) restructure institutional
environment in a manner that will either directly or
indirectly redistribute more income to themselves.
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The typical example of rent-seeking is the
monopolist example.
Firms seek government privilegies (such as
barriers to entry) to secure a monopoly and
therefore monopoly rents.
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Politicians are likely to offer policies where the
costs are widely diffused, but where the benefits
are more significant for a particular interest
group
Politicians have a strong incentive to favor special
interest even if action is inefficient.
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Therefore there may be bias in political decisions
towards public intervention
It may also explain why (certain) governments like
to finance expenditure by borrowing as opposed to
by levying taxes
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Widespread use of the taxing, spending, and
regulatory powers of government that favor
some at the expense of others will encourage
rent seeking.
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Rent seeking moves resources away from
productive activities.
The output of economies with substantial amounts
of rent seeking will fall below their potential.
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Actions of individuals, groups, or firms to
influence the formation of laws, regulations,
decrees, and other government policies to their
own advantage
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Examples:
An influential industrial group could buy off
legislators to erect barriers of entry in a
particular sector
 Ministry of public health can promote
primarily inrests of doctors, ministry of
transport interests of road construction
companies etc.
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Public choice theory has debated the extent to which
elected officials can control their bureaucratic agents.
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Bureaucrats often have more information than elected
officials about what they are doing.
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 Bureaucrats
have a motivation to support policies
and project promoted by interests groups because
these policies provide them with more power and
budgets
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The interests of bureaucrats are often
complementary with those of interest groups they
serve.
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Therefore, bureaucrats might have both ability and
motivation to implement policies or regulations that
go against the public interest.
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Issues that yield clearly defined current
benefits at the expense of future costs that
are difficult to identify.
 Political process is biased toward the adoption
of such proposals even when they are
inefficient.
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In the public sector, the absence of the profit motive
reduces the incentive of producers to keep costs low.
Neither is there a bankruptcy process capable of
weeding out inefficient producers.
Public-sector managers are seldom in a position to
gain personally from measures that reduce costs.
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 Public
sector is therefore biased toward higher
costs/lower efficiency
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The power of special interests
Rent seeking/redistribution of costs
The shortsightedness effect
Lack of incentives to
promote operational efficiency
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Economic theory of public Choice
and the voting process
Majority Voting:
Fails to take into account the strength
of the preferences of individual voters and may yield economically inefficient
outcomes
Benefit; Tax
An Inefficient “NO” Vote
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The NO vote wins but
is inefficient since...
300
250
200
(YES)
Adams
(NO)
(NO)
Benson
Conrad
Benefit; Tax
An Inefficient “NO” Vote
700
The NO vote wins but
is inefficient since...
MSB 1,150 > MSC 900
300
250
200
(YES)
Adams
(NO)
(NO)
Benson
Conrad
Benefit; Tax
An Inefficient “YES” Vote
The Yes vote wins but
is inefficient since....
350
350
(NO)
(YES)
(YES)
Adams
Benson
Conrad
300
100
Benefit; Tax
An Inefficient “YES” Vote
The Yes vote wins but
is inefficient since....
MSB 800 < MSC 900
350
350
(NO)
(YES)
(YES)
Adams
Benson
Conrad
300
100
examples of efficient and inefficient institutions (surviving due to
powerful groups)
 how institutions influence transaction costs (examples)
 social (voters) beliefs favouring inefficient institutional
arrangements
 how criminal law contributes to economic efficiency
 how property law contributes to economic efficiency
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how contract law/tort law contributes to economic
efficiency
 how regulation/deregulation contributes to economic
efficiency (example)
 regulatory solutions of market failures (example)
 means of regulation (examples)
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policies towards monopolies
 analysis and expamples of anti-trust law application
 types of anti-competitive behavior
 judgement by structure/performance in anti-trust (examples)
 recent antitrust cases
 regulation of financial markets (goals and examples)
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efficient social regulation measures (example)
 compliance costs of regulation (example)
 goals and measures of Basel III directive
 economic theory of public choice – main
principles
 possibilities of private provision of public goods (example)
 common reasons of government failure (example)
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special interest groups (example)
 rent-seeking behaviour/regulator capture
(example)
 economics of corruption (example)
 economic role and motivation of public bureaucracy
 rational ignorance of voters/economics of the
voting process
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Raise revenue for central & local government
Macro-economic demand-management
Achieve more equality in income & wealth
Correct externalities and other forms of market failure
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People should pay taxes according to their ability to
pay in accordance with the benefits derived from
government expenditure
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Taxes should be clear and certain
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Taxes should be convenient
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Costs of collection relative to the tax yield should be
minimal
Tax Theory: Distribution of the Tax
Burden
Benefits-Received Principle
Ability-to-Pay Principle
o Progressive Tax
o Proportional Tax
o Regressive Tax
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Tax Theory: tax rates
o Tax rate is the legally imposed rate. An income tax can
have multiple statutory rates for different income levels or it
can be a flat rate
o A progressive tax is a tax by which the tax rate increases
as the taxable base amount increases. "Progressive“ referres
to the way the rate develops as income increases
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Tax Theory: tax rates
o A flat (or proportional) tax is a tax system with a
constant tax rate.
o Usually the flat tax applies to corporate profits being
taxed at one rate.
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Tax Theory: tax rates
o A regressive tax is a tax imposed in such a manner that
the tax rate decreases as the amount subject to taxation
increases
o A regressive tax imposes a greater burden (relative to
resources) on the poor than on the rich — there is an
inverse relationship between the tax rate and the
taxpayer's ability to pay as measured by assets,
consumption, or income.
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Identify whether progressive, regressive,
or proportional
 Personal Income Tax
Progressive
 VAT or Sales Tax
Regressive
 Corporate Income Tax
Proportional
 Payroll Taxes
Proportional/Regressive
 Property Taxes
Regressive
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Properties of taxes: Direct Taxation
◦ Taxes on income and wealth
◦ Burden (liability) of tax cannot be shifted
 Income Tax
 Corporation Tax
 Tax on interest from savings
 Capital Gains Tax
 Inheritance Tax
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Usually taxes on spending
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Burden of the tax might be shifted from producer to consumer
depending on
◦ price elasticity of demand
◦ price elasticity of supply
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Examples
 Vat
 Excise duties
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The objects to which taxation is applied cover
 income
 wealth
 spending
Tax Theory: marginal and effective
tax rates
A marginal tax rate is the tax rate that applies to the last
euro of the tax base (taxable income or spending) – it
corresponds to the change in one's tax obligation as income
rises
The effective tax rate is the amount of tax an individual or
firm pays when all other government tax offsets or
payments are applied, divided by the tax base (total income
or spending).
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The value of a set of incomes, assets or outlays
(spendings) that is subject to taxation
The tax base may refer to that of an individual
asset, such as a house, or a pool of assets, such
as the tax base of all houses in a city. For
example, the property tax base of a house is its
value. The property tax base of a city is the
collective value of all taxable real estate in the
city.
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The tax base is affected by
 the number of tax-paying units
 the rates of tax
 tax allowances and tax reliefs
 the extent of tax evasion & avoidance
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Tax base can contract or expand
 Strong link with the economic cycle - in a recession
the tax base shrinks
 Extension of the range of objects to which taxation is
applied
 Changes in the economically active population
 “Fiscal drag” effects due to inflation
 Increased employment in low-paid jobs
 Scope of evasion & avoidance of tax paying units
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Tax avoidance is the legal utilization of the tax system
to one's own advantage. It is based on reduction of the
amount of tax that is payable by means that are within
the law
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Tax evasion, on the other hand, refers to the efforts by
individuals, firms and other entities to evade taxes by
illegal means.
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Both tax avoidance and evasion are unfavorable to a
state's tax system.
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keep overall tax burden as low as possible
 reduce marginal tax rates on income and business
profits to sharpen incentives to work
 maintain a broad tax base
 shift balance of taxation from taxes on income to
taxes on spending
 ensure taxes are applied equally and fairly
 use taxes to make markets work better (making
decision makers aware of external costs)
 raise revenue in ways that do least economic harm
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Law establishes from whom a tax is collected
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However, who ultimately pays the tax (the tax
"burden") is determined by the marketplace: taxes can
be shifted on other persons
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Economic theory suggests that the economic effect
of tax does not necessarily fall at the point where it
is legally levied.
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For instance, a tax on employment paid by
employers will impact on the employee, at least in
the long run.
Probable Shifting of Taxes
Corporate Income Tax
Stockholders – Consumers –Suppliers Employees
Sales and Excise Taxes
Consumers
Property Taxes
Renter
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Tax Efficiency
Administrative costs
Efficiency in collecting revenue
Possibility of tax evasion
Changes of economic motivations
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Deadweight costs of taxation
Taxes reduce economic efficiency, by introducing a
deadweight loss
It does not matter whether a tax on a good is levied
on buyers or sellers of the good
The price paid by buyers rises, and the price
received by sellers falls.
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Because of this, the quantity sold falls below
the level that would be sold without a tax
The size of the market for that good shrinks.
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Changes in Welfare
◦ A deadweight loss is the fall in total
surplus that results from a market
distortion, such as a tax.
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The change in total welfare includes:
◦ The change in consumer surplus,
◦ The change in producer surplus, and
◦ The change in tax revenue.
◦ The losses to buyers and sellers exceed
the revenue raised by the government.
◦ This fall in total surplus is called the
deadweight loss.
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What determines whether the deadweight
loss from a tax is large or small?
◦ The magnitude of the deadweight loss
depends on how much the quantity
supplied and quantity demanded respond
to changes in the price.
◦ That, in turn, depends on the price
elasticities of supply and demand.
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The greater the elasticities of demand and
supply:
◦ the larger will be the decline in
equilibrium quantity and,
◦ the greater the deadweight loss of a tax.
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The Deadweight Loss Debate
◦ Some economists argue that labor taxes are
highly distorting and believe that labor supply is
more elastic.
◦ Some examples of workers who may respond
more to incentives:
 Workers who can adjust the number of hours
they work
 Families with second earners
 Elderly who can choose when to retire
 Workers in the underground economy (i.e.,
those engaging in illegal activity)
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With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
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For the small tax, tax revenue is small.
As the size of the tax rises, tax revenue
grows.
But as the size of the tax continues to rise,
tax revenue falls because the higher tax
reduces the size of the market.
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As the size of a tax increases, its deadweight
loss quickly gets larger.
By contrast, tax revenue first rises with the
size of a tax, but then, as the tax gets larger,
the market shrinks so much that tax revenue
starts to fall.
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The Laffer curve depicts the relationship
between tax rates and tax revenue.
Supply-side economics refers to the views of
Laffer who proposed that a tax cut would
induce more people to work and thereby have
the potential to increase tax revenues.
Deadweight costs of taxation
 The only way to completely avoid deadweight costs
is to find taxes which do not change economic
incentives
 Examples cover a lump sum tax such as a poll tax
which is paid by all adults regardless of their choices,
or a windfall profits tax which is entirely unanticipated
and so cannot affect
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Additional Deadweight costs of
taxation: Tax Transparency
 The more complicated tax policy is, the more
opportunities for legal tax avoidance and illegal tax
avasion
These not only result in lost revenue, but involve
additional deadweight costs: for instance, payments
made for tax advice are essentially deadweight costs
because they add no wealth to the economy.
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Additional Deadweight costs of
taxation: Perverse incentives
 Complicated tax codes offer perverse economic
incentives.
 For instance, a sale from one company to another
might be liable for tax, but if the same goods were
shipped from one branch of a corporation to another, no
tax would be payable.
To address these issues, economists often suggest
simple and transparent tax structures which avoid
providing loopholes.
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Introduction of flat tax rate in some countries
Introduction of new lower rates of tax
Lower corporation tax rates
Switch towards indirect taxes (e.g. VAT and excise
duties)
Reforms to tax on personal savings and share
investments
Wider use of environmental taxes
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Energy production/consumption (eg.motor fuels)
Agricultural fertilisers & pesticides
Disposable household goods
Waste disposal
 household
 industrial
Water usage
Out of town car parking space
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Tax Freedom Day is the first day of the year in
which a nation as a whole has earned enough
income to fund its annual tax burden
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Capital expenditure
◦ highways; airports; schools; hospitals; defence equipment
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Current expenditure
◦ E.g. salaries of public servants, teachers & health care
workers; drugs used in the national health service
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Transfer payments
◦ welfare benefits to benefit claimants
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Debt interest
◦ payable to holders of government debt
Social Security
Health Care Services
Education
Debt Interest
Defence
Law & Order
Other functions
32%
17%
12%
7%
7%
5%
21%
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Cyclical trends in national output and employment
Demand for state provided public and merit goods
Social & demographic change
• long term changes in the age structure of the
population
• social changes (ie changes to the structure of
family life)
• income inequality and the scale of poverty
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Political decisions and priorities
Costs of publicly-provided goods & services
Interest Rates and Inflation Rate
Privatization Programme (affects the size of the
public sector)

The Public private initiative (PPI) is a new way for
the government to provide services for the public.

The government decides what service it wants to
provide, then the private sector finds the best way to
design, build, finance and operate that service in
partnership with the public sector.

Taxation of some benefits (inc. unemployment
benefit)

Reduction in eligibility (e.g. job-seekers
allowance)

Breaking of link between state pensions and
average earnings

Encouragement of private pensions and health
care

Increase of the pension age

Tougher criteria for claiming incapacity benefit

Freezing of child benefit (reducing its value in real
terms)

Gradual reduction in the real value of student
grants - replaced by a student loan component

The Budget Deficit is the annual difference between
Total Government Spending and Total Tax Revenues

It is the amount the government must borrow to
finance overall spending

Budget deficit dends to be quite volatile from year to
year

There is a strong link between the budget deficit and
the economic cycle

Combined annual borrowing of
 Central Government
 Local Governments
 Public Corporations
◦ Measured by
 nominal PSBR
 PSBR as percentage of GDP
 Borrowing
requires the issue of debt
(so-called government securities, e.g.Treasury bills,
Long-dated government bonds
 Debt
is sold to the financial sector, the non-financial
private sector and foreign institutions & individuals

Requires financing in the short-term
◦ higher interest rates to attract buyers of debt
◦ may “crowd out” funds available for private sector
investment

“Today’s borrowing is tomorrow’s taxation”
◦ Higher taxation to reduce the deficit
◦ Alternative is strict control of govt spending

High PSBR adds to future interest costs
◦ might have been spent elsewhere by the govt

When a government borrows only to finance
investment and not to fund day to day spending, it is
following the Golden Rule.

Public spending on current goods and services and
social security benefits should be met by taxes, but
investment for the future can be met by borrowing.


Budget deficits impose an unjustifiable
burden on future generations by raising their
taxes and lowering their incomes.
When the debts and accumulated interest
come due, future taxpayers will face a
difficult choice: They can pay higher taxes,
enjoy less government spending or both.


By shifting the cost of current
government benefits to future
generations, there is a bias toward too
large a public sector.
Deficits reduce national saving,
thereby retarding capital formation,
causing lower productivity, and
limiting real growth.


The deficit is only one small part of
fiscal policy. The problem with the
deficit is often exaggerated.
Intergenerational transfers may be
justified and some government
purchases produce benefits well into the
future (i.e. reducing budget deficit by
cutting spending on education).



A balanced budget requirement would limit
the policy options available to deal with
emergencies and future economic crises.
The government debt can continue to rise.
Population growth and technological
progress increases the nation’s ability to
pay the interest on the debt.
The budget deficit can be sustained
annually, at 5 percent of the total
government debt, or $28 billion.

How a budget deficit makes future
generations worse off.

How reducing the budget deficit might
make future generations worse off.
“A nation’s productive capability is determined
largely by how much it saves and invests for the
future.”


A nation’s saving rate is a key
determinate of its long-run economic
prosperity.
When the saving rate is higher, more
resources are available for investment
in new plant and equipment.


“Our society discourages saving in too many
ways, such as by taxing the income from
capital heavily and by reducing benefits for
those who have accumulated wealth and
capital.”
The consequences of high interest income
tax policies are: reduced saving, reduced
interest accumulation, lower labour
productivity, and reduced economic growth.


An alternative to current tax policies,
advocated by many economists is a
consumption tax like the VAT.
A person pays taxes only on the basis of
what they consume (spend) not on what they
produce. Income that is saved is exempt
from taxation until the saving is later
withdrawn and spent on consumption goods.


Most of the proposed changes in the tax
policies to stimulate saving would benefit
primarily the wealthy at the expense of
lower income groups.
High-income households save a higher
fraction of their income than low-income
households. Any tax change that favors
people who save will also tend to favor
people with high income.


Reforms would be either regressive or
would further the inequality of income in
our society.
Raising public saving by eliminating the
government’s budget deficit would provide
a more direct and equitable way to
increase national saving.

A large and growing part of government is
devoted to transferring income.
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4

There are three major reasons why large-scale
redistribution will reduce the size of the economic
pie:
◦ When taxes take a larger share of one’s income, the
individual reward derived from hard work and
productive service is reduced.
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5
◦ As public policy redistributes a larger share of
income, more resources will flow into wasteful rent
seeking activities.
◦ Higher taxes to finance income redistribution and an
expansion in rent-seeking will induce taxpayers to
focus less on income-producing activities, and more
on actions to protect their income.
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Role and impact of taxation (example)
Taxation and Tax evasion
The role of government subsidies
 Developments in tax policy
 Unemployment compensation benefits and fight
against unemployment
 Costs and benefits of the public health care

This is also known as Eurozone sovereign debt
crisis
The term indicates the financial problems
caused due to overspending by come European
countries
When a nation lives beyond its means by
borrowing heavily and spending freely, there
comes a point when it cannot manage its
financial situation.
The country may face insolvency (default): it is
unable to repay its debts.
The situation is worsened by the fact that
lenders start demanding higher interest rates


What causes a debt crisis to occur are a
slowed economic growth, declined tax
revenues, increased government spending,
or a combination of the factors.
One of the reasons for the debt crisis is a
corrupt government


The actual beginning is the year 1999
when the EU introduced the euro
Euro benefited countries such as
Portugal, Greece, Ireland, Italy and
Spain: it enabled them to borrow money
on much cheaper terms
Before these countries started to use euro as a
currency, they had to borrow money at interest
rates much higher than interst rates at which
such countries as Germany borrowed

When these countries started to use the euro
they could borrow money at interest rates close
to that of Germany

The rest of Europe in effect used Germany´s
credit rating. It borrowed as cheaply as Germany
could to buy things they could not afford

Also, in these countries the inflation rate was
higher than the rate of interest


It means that subjects were paid to borrow
As a consequence, both households and
goverments in these countries accumulated huge
amounts of debt

In the case of governments, this helped
politicians keep their constituencies of voters
happy

In several countries including Greece thus the
total public debt exceeded the yearly GDP even
though the limit for this indicator set in
Maastricht agreements was 60%

An example from Greece: a job which paid
55.000 euros in Germany paid 70.000 in Grece
even though the productivity of the Greek
economy compared with Germany was much
lower

To
get around pay restraints the Greek
government paid its employees 13th and even
14th month salary

Also, the Greek government cathegorized
certain jobs as „arduous“. These jobs had a
retirement age at 55 for men and 50 for women.

More
that 600 Greek professions somewhat
managed to get themselves classified as arduous,
among them hairdresser, radio announcers,
musicians etc.
All
this led to even higher governemt borrowing

An example form Spain:
Due to intensive borrowing, Spain had the
biggest real estate bubble in the world - it
reached higher number of unsold homes
than the U.S. whose economy is six times bigger

Most of these new homes were financed using
capital borrowed from abroad

Every time there are default threats, the
European Central Bank helps out with a bail-out

Since the start of the financial/debt crisis the
ECB has bought, outright, around 80 billion USD
of Greek, Irish and Portugese government bonds
and lent another 450 billlion USD to various
European governments and banks accepting
practically any collateral including Greek
government bonds


The situation, however, is interlinked:
In case of Greece, many German and French
banks which have lent money to the Greek
government would be in trouble if Greece
defaulted

An example: the German governemt gives
money to the European rescue fund so that it can
give money to the Irish governemt so that it could
give money to Irish banks so they could repay
their loans to the German banks


Question:
Would
not it be easier for the German
government to just pay the German banks to
separately, instead of taking this long and
convoluted route?
An
example outside the eurozone:
In 2004, interest rates in Hungary were at 12.5
per cent. This meant borrowing money was
extremely expensive,
In neighbouring Austria, the banks offered loans
and mortgages at 2 per cent,
So the Austrian banks, many of which had
branches in Hungary began to lend to Hungarian
borrowers.
Austrian banks have lent 140% of their GDP to
countries like Hungary.
Even though Hungary has put in austerity
measures and is trying to repay, if there was a
blow up, the Austrian government wouldn't be
able to save the banks and ECB might have to
step in
Similar is the case of Swedish banks which have
also lent a lot of money to Estonia, Lithuania and
Latvia, countries which aspire to have Euro as
their currency some day
If, theoretically, countries go back to their own
currencies to print it and repay debt, citizens will
be affected.
When a country prints currency in huge
quantities, the currency will not remain of any
real value.
So the citizens of the country will try and move
their money to either other assets like gold, or
will continue using the euro.
This will lead to bank runs, with all the people
queuing up at banks at the same time demanding
their money back.
This, of course, will lead to a lot of banks
collapsing

A hypothetical example of Italy:
Households and firms, anticipating that domestic
deposits would be redenominated into the lira
which would then lose value against the euro,
would shift their deposits to other euro-area
banks.
A system-wide bank run would follow.

A hypothetical example of Italy:
Investors anticipating that their claims on the
Italian government would be redenominated into
lira would shift into claims on other euro-area
governments, leading to a bond market crisis. . .
this would be the „mother of all financial crises“


Emergency loans have been extended as
bailouts mainly by stronger economies like
Germany and France, and also by the IMF.
The EU member states have also created the
European Financial Stability Facility (EFSF) to
provide emergency loans.

Restructuring of the debt

Austerity measures have been enforced.