Options to Reduce Public Deficits to 3% of GDP by 2014 Persistent deficits lead to: Rising interest rates which crowds out private spending Future tax uncertainty which reduces business/consumer confidence/spending Spending Options:$ bn Raise Social Security retirement age to 70 (eligibility of 67 by 2027 currently) 4 Change benefit inflation index to one less upwardly biased 10 Reduce starting Social Security benefit for most workers 7 (initial benefit indexed to wages for low income, inflation for others) Raise Medicare age to 67 from 65 3 Convert Medicaid share to block grants (to reduce distorted state cost incentives) 47 Reduce Medicaid share to wealthy states (eliminate 50% floor on federal share) 22 Reduce highway funding and farm assistance 8 Total: $101
Options to Reduce Public Deficits to 3% of GDP by 2014 Other tax options: Implement 5% VAT (Value Added Tax at each stage of production)324 Cap employer health-insurance deduction to average premium 70 Raise federal fuel tax by 50 cents a gallon to 68 cents 62 Carbon-emissions tax (or Cap-and-Trade system) National sales tax (to reduce dependence on income tax which penalizes work and investment) The U.S. tax system needs less complexity, more bias towards taxing consumption and elimination of loopholes to broaden income-tax base which will allow for the lowering of tax rates.
A Closer Look at the Multiplier Key Macroeconomic relationships C = C + MPC(1-t)YConsumption function t = marginal tax rate I = IPlanned Investment function G = GGovernment purchases function X = XExport function M = MPI(Y)Marginal Propensity to Import, ( M/ Y) AE = C + MPC(1-t)Y + I + G + X - MPI(Y) Y = AE = C + I + G + X – M Equilibrium Condition Assume: Y E excess capacity => fixed price level => flat SRAS curve An Expression for Equilibrium Real GDP Y = C + MPC(1-t)Y + I + G + X - MPI(Y) Y – MPC(1-t)Y + MPI(Y) = C + I + G + X Equil level of GDP Y* = 1 [C + I + G + X] 1 - [MPC(1-t) – MPI]
An Expression for Equilibrium Real GDP Y* = 1 [C + I + G + X] 1 - [MPC(1-t) – MPI] Change in Variables Y* = 1 [ C + I + G + X] 1 - [MPC(1-t) – MPI] Government Purchases Multiplier Y* = 1 G 1 - [MPC(1-t) – MPI]
The Circular Flow Diagram
Employment Cost Index (Most Comprehensive Measure of Labor Costs) Web address: www.stats.bls.gov/news.release/eci.toc.htm Annual revisions with release of first quarter data which can go back several years. The employment cost index (ECI) is an early warning system for rising inflation which can push interest rates higher and stock prices lower. ECI is the best harbinger of pricing pressures and is a forerunner of inflation. Labor costs typically make up 70% of a firm’s operating costs. Employment costs = wages/salaries and fringe benefits. Rising compensation costs can result in various responses by firms: Raise retail prices => inflation. Absorb expense and maintain prices => falling profits => falling stock prices. Increase capital investment to raise productivity and reduce workforce. Reallocating production facilities by decreasing domestic production and increasing foreign production => increasing unemployment and unemployment insurance costs => increasing government spending and deficits. Wage-price spiral (a vicious cycle the Federal Reserve will try to stop) labor expenses => retail prices => workers demand for wages/salaries => retail prices (self-perpetuating inflation escalation) Every quarter the BLS surveys 8,500 private and 800 public sectors (local and state only) on labor cost issues. Survey is done for the pay period that includes the 12 th day of March, June, September, December. Wage and salary data include bonuses, incentive pay, commissions, and cost of living adjustments. Benefits data include insurance benefits, retirement savings benefits, paid vacations, sick leave, holidays, premium pay for overtime, shift differentials, social security, Medicare, federal-and state mandated social insurance programs. Data is converted to index where June 1989 = 100 Labor Costs relative to Productivity If annual compensation costs are rising (tight labor markets) faster than annual changes in non-farm productivity (falling marginal product of labor), then economy may be facing inflationary pressures. Strong productivity growth => profits => wages and salaries. The monthly Employment Report’s average hourly earnings (AHE) is another good indicator of wage inflation. But AHE covers only workers who receive hourly pay (not salaries) and does not include benefits, whereas the ECI covers both hourly and salaried workers. ------------------------------------------------------------------------------------------------------------------------------------------------------------------ Market Analysis: Bonds: Unexpected big ECI without big in productivity => ( P/P) E t+1 => D Bonds => i Bonds => fed funds rate by Fed to stop wage-price spiral Stocks: Unexpected big ECI without big in productivity and economy operating above potential => business costs => profits => P Stocks Dollar: Unexpected big ECI without big in productivity and economy operating above potential => interest rates => capital inflows => increase value of dollar. But an ECI => U.S. export competitiveness => exports/ imports=> trade deficit => exchange rate.
$53 Trillion unfunded liabilities Bank stock purchases (TARP) Stimulus plan Mortgage bailout plan Income-support programs Recession-induced falling revenues