Can Removing the Tax Cap Save Social Security?

September 28, 2014

By Shantanu Bagchi

The maximum amount of earnings in a calendar year that can be taxed by Social Security in the U.S. is currently capped at $106,800. In this paper, I use a general-equilibrium overlapping-generations model to examine if removing this cap can solve Social Security’s budgetary problems. I find that in general, removal of the cap increases Social Security revenues, but by only a small percentage, and most of these extra revenues go towards paying benefits to high-income retirees no longer subject to the cap. Even when the cap is removed only from taxes but retained on the amount of earnings creditable towards Social Security benefits, the fiscal advantages are quite small.

I consider this paper part of a new research agewnda that seeks to determine whether taxing more the rich can help reduce budget shortfalls. Two papers discussed a month ago did not find much margin as one would hope, and this one confirms it if you focus solely on old age pension, which turns out not to be that great at revenue generating or redistribution.

The great housing boom of China

September 15, 2014

By Kaiji Chen and Yi Wen

This paper provides a theory to explain the paradoxical features of the great housing boom in China —the persistently faster-than-GDP housing price growth, exceptionally high capital returns, and excessive vacancy rates. The expectation that high capital returns driven mainly by resource reallocation are not sustainable in the long run can induce the very productive entrepreneurs to speculate in housing during economic transition. This creates a self-fulfilling growing housing bubble, which can create severe resource misallocation. A calibrated version of the theory accounts quantitatively for both the growth dynamics of house prices and other salient features of the recent Chinese experience.

My trip to China last year gave me a big puzzle. Why are housing prices skyrocketing when there is an unbelievable amount of construction going on and entire satellite cities that appear empty? This paper is showing this can indeed happen, and it does not look good for the future.

News Driven Business Cycles: Insights and Challenges

September 10, 2014

By Paul Beaudry and Franck Portier

There is a widespread belief that changes in expectations may be an important independent driver of economic fluctuations. The news view of business cycles offers a formalization of this perspective. In this paper we discuss mechanisms by which changes in agents’ information, due to the arrival of news, can cause business cycle fluctuations driven by expectational change, and we review the empirical evidence aimed at evaluating its relevance. In particular, we highlight how the literature on news and business cycles offers a coherent way of thinking about aggregate fluctuations, while at the same time we emphasize the many challenges that must be addressed before a proper assessment of its role in business cycles can be established.

If you are interested in how news and expectations in general matter for the business cycle, this is a must read. Beaudry and Portier have been very influential in getting this literature moving with modern methods. Much like the topic, the paper is also forward-looking in the sense that it opens all sorts of avenues that merit exploration.

Housework and Fiscal Expansions

September 8, 2014

BY Stefano Gnocchi, Daniela Hauser and Evi Pappa

We build an otherwise-standard business cycle model with housework, calibrated consistently with data on time use, in order to discipline consumption-hours complementarity and relate its strength to the size of fiscal multipliers. We show that if substitutability between home and market goods is calibrated on the empirically relevant range, consumption-hours complementarity is large and the model generates fiscal multipliers that agree with the evidence. Hence, our analysis supports the relevance of consumption-hours complementarity for fiscal multipliers. However, we also find that explicitly modeling the home sector is more appealing than restricting to the consumption-leisure margin and/or to the preferences proposed by Greenwood, Hercowitz and Huffman (1988). A housework model can imply substantial complementarity, without low wealth effects contradicting the microeconomic evidence.

It has been fashionable again to look at home production, and it is important. Indeed, it is difficult to understand the labor supply without its outside option. And this paper is a nice example of why it matters.

Debt Dilution and Sovereign Default Risk

September 2, 2014

Juan Carlos Hatchondo, Leonardo Martinez and Cesar Sosa-Padilla

In this study, we measure the effects of debt dilution on sovereign default risk and consider debt covenants that could mitigate these effects. First, we calibrate a baseline model of defaultable debt (in which debt can be diluted) with endogenous debt duration, using data from Spain. Secondly, we present a model in which sovereign bonds contain a covenant that eliminates debt dilution. We quantify the effects of dilution by comparing the simulations of the model with and without this covenant. We find that dilution accounts for 79 percent of the default risk in the baseline economy. Without dilution, the optimal duration of sovereign debt increases by almost two years. Consumption volatility also increases, but eliminating dilution still produces substantial welfare gains. Introducing debt covenants that could be easier to implement in practice has similar effects. A covenant that penalizes the government for bond prices below a threshold is more effective in reducing the default frequency. A covenant that penalizes the government for debt levels above a threshold is more effective in reducing consumption volatility. These covenants could be useful for enforcing fiscal rules.

I wonder how politicians would react to the idea of commitment. Still, the idea that you want to force yourself not to abuse the privileges that sovereign debt gives you has a lot of merit, especially when short-sighted politicians have no interest in building credibility.