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Finance 30220: Macroeconomic Analysis

Finance 30220: Macroeconomic Analysis. Recent Macroeconomic Controversies. Distribution of Household Income: 2004. Median Household Income = $45,000. Total Households = 112M. Source: US Census Bureau (www.census.gov). Average vs. Median Income (1979 = 100).

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Finance 30220: Macroeconomic Analysis

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  1. Finance 30220: Macroeconomic Analysis Recent Macroeconomic Controversies

  2. Distribution of Household Income: 2004 Median Household Income = $45,000 Total Households = 112M Source: US Census Bureau (www.census.gov)

  3. Average vs. Median Income (1979 = 100) Source: US Census Bureau (www.census.gov)

  4. US Income Quintiles Source: US Census Bureau (www.census.gov)

  5. The Lorenz Curve The Lorenz curve plots the cumulative distribution of US income

  6. The Gini Coefficient The US currently has a Gini coefficient of .45 0 = Perfect Equality 1 = Perfect inequality

  7. Rising Inequality in the US? • The Gini Coefficient has been steadily rising in the US from a low of .35 to a current level of .44 • The increase in the Gini coefficient has accelerated in recent years.

  8. The Good Old Days: Economic Growth from 1947-1973

  9. The Times, They are a Changin’: Economic growth from 1977-1989

  10. Why is income inequality rising? • New technologies favor skilled labor (an increase in the “skill premium”) • Increasing importance of international trade • Decline of labor unions Should we be doing something about this? And if so, what?

  11. The Bush Tax Cuts of 2001 & 2003 Had four main components: • Across the board reductions in marginal tax rates • Increase in the child tax credit, and a reduction in the “marriage penalty” • A repeal of the estate tax • A reduction in the tax rate on dividend payments

  12. What do we mean by the “cost” of a tax cut, anyways? The bush tax cut was advertised as “the largest tax cut in history”. However, when put in equal units, the Bush tax cut was actually relatively modest compared to earlier policies.

  13. Suppose that the Johnson family has a household income of $50,000. Currently, the income tax rate is 20%. Under the current tax code, the Johnsons pay $10,000 per year in Taxes. The cost of the tax cut is the $5,000 in lost revenues If the government cuts the tax rate to 10%, then the Johnson’s tax bill falls to $5,000 Suppose that a drop in the marginal rate encourages Mrs. Jones to go back to work. With the two income earners, the Jones family income rises to $120,000. At the 10% rate, their tax rises to $12,000 Could this happen?

  14. Tax Revenues = (Tax Rate) (Tax Base) The basic logic behind the Laffer Curve is that the tax base should be negatively related to the tax rate. Tax Revenues Are taxes too high or too low? Tax Rate 0% Revenue Maximizing Rate 100%

  15. Tax Revenues History suggests that taxes are two high, but be careful… Tax Rate 0% Revenue Maximizing Rate 100% Source: Congressional Budget Office

  16. The Social Security Act was signed into law by President Roosevelt on August 14, 1935. In addition to several provisions for general welfare, the new Act created a social insurance program designed to pay retired workers age 65 or older a continuing income after retirement. By late 1937, every American had a social security number John David Sweeney of New Rochelle, NY had the first official Social Security account – his number was 055-09-0001 The lowest number belonged to Grace Owen of Concord, NH – her number was 001-01-0001 The first benefits were paid in 1940

  17. Social Security numbers are assigned NOT in numerical order, but based on area – each state is assigned a set of area numbers. For example, Indiana uses area numbers 303 - 317 Group numbers are done using an “odd – even” system Some Possible Sequences First Groups 01 03 05 07 09 305 – 52 - 5555 305 – 52 - 5556 Second Groups 305 – 52 - 9999 306 – 52 - 0001 10 12 14 … 98 NOT 305 - 54 - 0001 Third Groups 02 04 06 08 10 317 – 52 - 9999 303 – 54 - 0001 Fourth Groups 11 13 15 … 99

  18. Old Age, Survivors, and Disabilities Insurance (OASDI) is the official name for social security (also called the “Payroll Tax”). Social Security is paid out of gross income – your contributions are matched by your employer Medicare: 1.45% Social Security: 6.2% Maximum Taxable Income: $94,200 (Maximum Annual Tax = (.062)($94,200) = $5,840.40 (Roughly $1,800/wk)

  19. The first step to calculating your benefits is to calculate your average indexed monthly earnings (AIME) For every year in which you had earnings, multiply that number (or the yearly maximum – whichever is bigger) by the index factor for that year – this converts your earnings to current dollars Add up the 35 highest years and then divide by 420 (the number of months in 35 years) – this is your AIME

  20. AIMEBenefit Rate $0 - $656 90% $657 - $3,955 32% $3,955 + 15% You get full benefits if you retire at age 66. Your benefits are reduced by 25% if you retire at 62. Benefits are capped at $2,053/mo. Example #1: Mr. Jones has an AIME of $750 (Roughly $9,000 per year) AIMEBenefit Rate $0 - $656 90% $657 - $750 32% (.90)($656) = $590.40 (.32)($ 93) = $ 29.76 $620.16 (Retire at 66) Example #2: Mr. Smith has an AIME of $5,000 (Roughly $60,000 per year) AIMEBenefit Rate $0 - $656 90% $657 - $3,955 32% $3,955 - $5,000 15% (.90)($656) = $590.40 (.32)($3,298) = $1,055.36 (.15)($1,045) = $156.75 $1,802.51 (Retire at 66)

  21. The Federal Budget (Fiscal Year 2005) Individual Income Taxes: $1,082B Corporate Income Taxes: $278B Social Security Tax: $794B Other Mandatory Spending: $985B Discretionary Spending: $968B Social Security Payments: $519B + + Total: $2.154T Total: $2.472T Social Security Surplus = $794B - $519B = $275B Non-Social Security Deficit = $1,360B - $1953B = - $593B Net Deficit = $318B Since its creation, the social security system has run a surplus (social security payments are less than social security taxes). The government has used this surplus to fund other programs. This is done by selling Treasuries to the social security administration. The social security trust fund currently holds around $2T worth of US treasuries!

  22. The social security system has relied on the fact that there are a lot more people currently working than currently collecting benefits. This won’t always be the case • 1935: 9 workers for every 1 retiree • 2005: 3.5 workers for every 1 retiree • 2010: 1.5 workers for every 1 retiree Trust fund exhausted – revenues sufficient to cover 70% of benefits Social security payments exceed social security taxes 2022 2014 2034 Social security payments exceed social security taxes plus interest on trust fund

  23. The payroll tax (social security tax) is a highly regressive tax. Annual Income: $20,000 Payroll Tax Paid: $1240 Effective Rate: 6.2% Annual Income: $100,000 Payroll Tax Paid: $5840 Effective Rate: 5.8% Annual Income: $500,000 Payroll Tax Paid: $5840 Effective Rate: 1.1% Effective Rate 6.2% 3.8% 1.1% Income $20,000 $150,00 $500,000

  24. Consider Homer Simpson, safety inspector at the local nuclear power plant. Homer earns $7,000 per year (poor sap!).Lets assume that he starts working at 21 and retires at 66. Under the social security system, total contributions for Homer would be 12.4% of $7,000, or $868 per year. Suppose, instead, that the $868 in contributions were put into a 401K earning 4% per year. During retirement, Homer’s monthly social security benefit would be $525. At retirement, Homer’s 401K would have a balance of $105,053. The monthly interest earned would be $350

  25. Consider Apu Nahasapeemapetilon, owner of the local Quickie Mart. Apu earns $15,000 per year. Lets assume that he starts working at 21 and retires at 66. Suppose, instead, that the $1860 in contributions were put into a 401K earning 4% per year. Under the social security system, total contributions for Apu would be 12.4% of $15,000, or $1860 per year. At retirement, Homer’s 401K would have a balance of $225,114. The monthly interest earned would be $750 During retirement, Homer’s monthly social security benefit would be $780.

  26. Consider Montgomery Burns, owner of the local nuclear power plant. Monty earns $150,000 per year. Lets assume that he starts working at 21 and retires at 66. Under the social security system, total contributions for Monty would be 12.4% of $94,200, or $11,680 per year. (the maximum) Suppose, instead, that the $11,680 in contributions were put into a 401K earning 4% per year. At retirement, Homer’s 401K would have a balance of $1,413,613. The monthly interest earned would be $4,712 During retirement, Homer’s monthly social security benefit would be $2,053. (the maximum)

  27. Over the years, social security tax rates have increased, while benefits have decreased. This has caused the implied rate of return in the system to decline over the years. Year of Birth Those that are just entering the system have an implied return of less than 1%! 10% 6% 2% 1905 1925 1960 Implied Return

  28. Recently, there have been discussions about “privatizing” the social security system. Under a privatized system, individual payroll tax contributions would be placed in individual accounts to be invested – very much like a 401K plan. • Benefits • Higher return on investments will generate more retirement income • Increased saving should lower interest rates and promote more new capital formation • Individuals would be able to pass social security account balance to heirs • Social Security would be a self sustaining system, independent of population changes • Costs • Financial risk passed on to households • What do we do with lower income households? • Administrative costs would increase dramatically • Do we want the government to be a big player in financial markets? • How do we transition to the new system? (Current Social Security liabilities are around $25T!!)

  29. The Minimum wage was first established in 1938 at $.25/hr • In 2002, 72 million US workers were paid on an hourly basis (60% of all workers) • 2.2 Million reported hourly wages at or below $5.15/hr (3% of all workers). This number is down from 13% in 1979.

  30. States have the option of choosing a state/cities minimum (San Francisco has a minimum wage of $8.50) – if Federal and state wages differ, the larger of the two is applied

  31. What’s the profile of the average minimum wage worker? • Minimum wage earners tend to be young. • 50% are under 25 • 25% are between 16 and 19 • Women are more likely to be on minimum wage • 4% of women • 2% of men • Part time workers are 4 times more likely to be on minimum wage (8% vs. 2%) • Most minimum wage workers have less than a high school diploma • 2% of high school graduates • <1% of College Graduates • 63% have never been married • By occupation, the largest proportion come from service industries (roughly 2/3 of all minimum wage workers – mostly food service) • By geographic region, the South had the highest proportion (4%). The West has the lowest (2%)

  32. The important issue surrounding the minimum wage is: “What is the purchasing power of minimum wage workers?” The minimum wage is set in nominal terms. Therefore, periods of high inflation will erode the purchasing power of the minimum wage. The minimum wage tends to average around 40% of the average hourly wage.

  33. Minimum wage workers tend to be at or below the poverty threshold

  34. Do we need a “living wage”? If so, what should it be? The minimum wage is currently at $5.15 per hour. Assuming 40 hours per week and 50 weeks per year, this translates into an annual salary of $10,300 – essentially equal to the poverty threshold for a single person. A living wage has often been defined as hourly wage that will raise a family of four with one income earner to 125% of the poverty threshold. This suggests a “living wage” equal to $12.59 per hour (a 244% increase from its current level.) The poverty threshold for a family of four is currently $20,144.

  35. Does the Minimum Wage Cause Job Loss? • Studies suggest that at the aggregate level, any job loss due to minimum wage is negligible. • One notable exception is teenage employment. A 10% increase in the wage rate lowers employment by roughly 3% • Employers have several methods of absorbing minimum wage costs (lower benefits, higher prices, etc) Minimum Wage $4 Unemployment

  36. Suppose that the current hourly wage is $4. At that wage, 100 hours are being supplied. Now, suppose that the government imposes a $2 per hour tax on labor – to be paid by employers. As a result, hours drop to 90, wages (before tax) fall to $3. Taxes Collected = ($2)(90) = $180 $5 $4 If those tax revenues are redistributed back to those still working, the hourly “after tax” wage rises to $5 $3 90 100 How is this different from simply increasing the minimum wage to $5?

  37. The minimum wage, if you think about it as a tax, is a very strange tax. The minimum wage taxes a rather small subset of employers in the US (those employers that pay the minimum wage) Revenues “collected” by this tax are distributed to minimum wage workers (most of which are teenagers) If our desire is to transfer income from one group to another, why don’t we use the system already in place? (Earned income tax credit, welfare, etc)

  38. In 2005, the federal government spent $2.472T. IN the same year, the government raised $2.154T in taxes. The difference ($318B) was financed by issuing US Treasuries. This represents about $1,000 per person in the US. This, however, is only new debt. Total debt outstanding is a bit larger…. Roughly $30,000 per person!!!!

  39. In 1993, Harry Figgie wrote a book entitled “Bankruptcy 1995”. In it, he argued that by 1995, interest payments on our debt would surpass total taxes collected. At that point: • The government would be forced to default on its obligations – this would cause financial markets to crumble • The government would be forced to raise taxes to stifling levels • The government would pay the debt by printing money – this would cause a hyperinflation ala Germany in the 1930s. Could this actually happen?

  40. Total Federal debt in the United States seems to be growing at an alarming pace!!

  41. However, debt as a percentage of the overall economy has been (until recent years) falling. Debt Growth = 5.5%/yr GDP Growth = 6.5%/yr

  42. Alternatively, consider interest payments on the debt as a percentage of the overall federal budget. As a benchmark, the defense budget is currently around 18% of the total. Defense Budget

  43. Can an excessive debt burden hamper our economy’s ability to grow (and, hence affect our ability to repay it)? Supply The traditional argument is that government raises the demand for loans – this increases the interest rate and “crowds out” private investment Demand Loans However, as long as the supply of loans (aka savings) can keep pace with the rising demand, interest rates don’t have to rise.

  44. The Large Deficits of the mid-eighties were associated with falling interest rates. In fact, the correlation between government borrowing and interest rates is near zero

  45. Further, there doesn’t appear to be any obvious relationship between economic growth and the evolution of the government debt relative to GDP GDP Growth Debt (% of GDP)

  46. It seems that savings is keeping pace with our borrowing….the real issue is the source of that savings…. Currently, the US is borrowing $2B PER DAY from the rest of the world. In fact, the US consumes 80% of total available funds worldwide!!

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