Sugar tax - flawed thinking?

As IB students approach their first IA I'm posting this story to remind you about the UK 'Sugar tax'.

The article focuses on a group, "The Taxpayers Alliance", who oppose the tax (very Australian - any tax is a bad tax attitude). They point out that the tax is not being applied to all drinks with high sugar content.  They also suggest that the tax is regressive.

A sugar tax intends to address a negative externality of consumption and was dealt with in a post on 19th February. However the economics of it is shown in the diagram below. People don't understand how their consumption of the good is not as good for society (and them) as their perceived private benefit.

The first point made by the group is that the tax is not being applied to other sugary drinks. This is a fair point in some respects. Perhaps those who drink fizzy sugary drinks will switch to untaxed drinks due to the change in relative prices. This expose an important flaw in taxation policy, and suggests that applying the tax across a wider range of goods might be advisable.

However the criticism miss the point. Young people (and some older ones) can drink litres of fizzy drinks, but are unlikely to drink litres of hot chocolate. The problem is not the sugar content per 100ml, but the amount consumed. So if people swap a litre of fizzy drink for a hot chocolate then less sugar is consumed.

The second point made is that the tax is regressive. This means that the poorer households pay a higher proportion of their income in tax than richer households. This is usually true of specific indirect taxes. Should we be worried about this? In short, probably not. The sugar tax is designed to change behaviour. If households buy fewer fizzy drinks then they don't pay the tax and that's what the government wanted. If they carry on buying fizzy drinks then they are paying more towards their medical treatment.

Maybe the Taxpayers Alliance should have claimed the elasticity of demand was not conducive to reducing consumption instead?

The BBC article is here

This article is more relevant to IB students because of its international nature. However VCE students should be aware of the impact of, justification for and limitations of indirect tax.

A problem of supply side reform

France has an unemployment rate of 10.5%, far higher than other EU countries of similar standing (but not as high as the basket cases of Spain, Portugal, Italy and Greece). That France's unemployment has been consistently higher than the UK's and Germany's really should concern the French.

The charts below show the French and UK unemployment rates. They show that UK unemployment has been consistently lower than Frances and that the UK has recovered from the Global Financial Crisis while France has not. Yet these two countries are neighbours, with broadly similar populations and similar industrial/service based economies.

One explanation offered for this is France's inflexible labour market. The maximum working week is set at 35 hours, there are strict laws about when people can work, generous minimum paid holiday (30 days a year compared to Germany's 20) and employment protection which makes it very difficult for firms to let workers go.

The French government wish to relax labour laws so that while those in work might be a little worse off there will be more jobs overall. 

This is a supply-side policy and copies the process begun in their neighbour, the UK, as early as 1981. This type of supply-side policy is called deregulation. The hope is that the reforms will give firms greater flexibility, so they become more responsive to customers and profitable, and encourage them to take on more employees because there is less risk they become 'stuck' with staff they don't need.

This is being strongly opposed by French Trade Unions who are engaging in nationwide strikes.

The article below explains the policy changes and also suggests that this is a battle between those currently in work and those who would like to be, but can't get jobs in the current climate.

The data certainly suggests that there is something stopping the French labour market from working efficiently and that this will cost France economic growth and give the French generally a lower standard of living.

The BBC article is here

This article is more directly applicable to IB students, but VCE students also need to understand the nature of Supply-side policies and their effects and also the difficulties that can be encountered in implementing them. There is no doubt that creating a more flexible labour market is one aim of supply-side policy and it will result in lower wage rate, but higher employment in the short-run, while allowing higher long-run growth.

What should the inflation target be?

Central banks around the world have taken to adopting an official target for inflation since the 1990's. This was the result of the failure of all previous attempts to manage inflation and included exchange rate targets, fixed exchange rates and controlling the supply of money.

To the surprise of most the targeting of inflation has worked (although arguably this allowed conditions for the GFC to occur). The target adopted is met by influencing the demand for money by manipulating interest rates - the price of money. It is accepted however that there are 'long and variable' lags in such monetary policy and so most central banks try to manage the inflation rate over the next two years rather than influence the next set of inflation figures.

The policy of adopting a target that is not 0% inflation (very popular among politicians as an aim in the 1970's and 80's) is that there are benefits and costs of low and stable inflation, Most central banks have adopted a target of around 2% on the CPI measure. For example the Bank of England have a 2% target with a 1% margin either side before they must explain their failure. The Australian central bank, the RBA, has a target of 2 to 3% over the economic cycle.

The Australian target is much more flexible than the Bank of England target, but seems the same type of price stability. Enough inflation to allow changes in the economy and growth, but not so much that it threatens the efficiency of the price mechanism. All central banks know that it is price volatility that causes the greatest harm.

Presently inflation is below target in most OECD countries. This has led to some people saying that the targets are now too low and should be adjusted downwards. This is to ignore the dangers that too low an inflation rate can bring. In Australia's case the country is too at risk of price fluctuations due to volatile commodity markets and a lower target could easily lead to deflation.

In the article below the views of the Governor of the RBA are discussed on why the inflation target should not be changed.

The Financial Review article is here

This article focuses on Australian monetary policy and so is of interest to VCE students, in particular because it talks about current policy and the influences on decision making. IB students are also required to have detailed knowledge on monetary policy and examples of its workings.

British supermarkets - oligopoly case study

The UK has had four 'big supermarkets' since the 1980's. The market changed from one where the largest retailer held just 7% of the market to one where the largest, Tesco' had more than 25%. The chart below shows the 2014 market shares (the article linked below has a more up to date set of data, which you should compare).

Note that while there is technically a 'Big Four' the relative market shares of the four vary considerably.

Economic theory tells us that in the oligopoly market structure there are significant barriers to entry and firms are highly interdependent. It also tells us that there is a strong likelihood that firms will avoid damaging price wars because they fully understand their mutual interdependence and they all loose if they compete on price.

The article below describes how Asda are loosing both sales and profits as the market fights exactly the sort of price war we have been led to believe won't happen. This is because there are several players trying to gain additional market share. This is Aldi and Lidl, who are aggressively expanding.

So what is wrong with the oligopoly theory in this case? Actually nothing. There are strong barriers to entry in this market. The existing players have strong brand loyalty and occupy many prime locations, and they have the money to fight by advertising and discounting. However Aldi and Lidl have the money to fight too.

The barriers to entry are not high enough to prevent them entering the market and engaging in a price war. Their tactic is to sell cheap, the existing supermarkets like to emphasise quality as well, but that isn't enough to stop them.

The supermarket market is contestable if you have the financial reserves to obtain the stores and accept low profit margins. 

Who are the winners? Consumers are getting lower prices as a result of this competition, also the 'monopoly power' of the biggest players is falling which will make it harder to raise prices in the future. 

Who looses? The existing firms for sure. However suppliers of the supermarkets are coming under pressure to cut their prices so the supermarkets can cut theirs due to the market power of supermarkets as buyers. There are already stories of farmers who cannot survive on the prices they receive and other firms feeling 'bullied' to cut prices or lose the contract.

The BBC covers the story here

Work out the changing four firm concentration ratio in this market. Google can provide charts that show shares that go back further than 2014.

This article is most appropriate for IB students who require a firm understanding of how oligopoly markets might work and need examples they can compare to theory. VCE students do require a knowledge of market structure and so it is still useful for them.

Wage growth means that inflation is likely to be weaker

The causes of inflation are complex. They can be boiled don to demand-pull and cost-push forces, but in reality the forces that drive the inflation rate are complex and numerous variables feedback to influence others. The Monetary Policy Committee of the Bank of England monitor over 1500 different statistics to reach their judgement on the path of future inflation.

One variable that is important is wages growth. Wages feed through into inflation because they affect the cost of production. If wages are rising more slowly then it is fair to assume that the upward pressure on prices will be reduced. This would be classified as lower 'cost-push' pressure on inflation.

However lower wages growth is quite probably associated with low demand pressures. There isn't enough Aggregate Demand for firms to be competing for scarce labour resources. When there is high Aggregate Demand labour shortages cause wages to be bid up faster.

Australian wages growth is now the lowest it has been for twenty years. This suggests low inflationary pressure and the article below suggests that this means the Reserve Bank of Australia will cut interest rates again soon.

It would be a mistake to say this is low cost-push' inflationary pressure alone, because the problem begins on the demand side of the economy.

The Guardian article is here

This article is relevant to IB and VCE economics. VCE students need to know the demand and supply side influences on the Australian economy and how these are affecting the macroeconomic goals of the economy. IB students also need to understand the process of inflation and its various influences.

Will lower interest rates work?

The Australian central bank, the Reserve Bank of Australia (RBA), reduced interest rates to a record low of 1.75% last week. The financial markets are sure this is not the last cut in interest rates with some forecasting a rate of 1%, but everyone is sure 1.5% will be seen soon.

The cash rate is Australia's 'bank rate' the lowest rate at which commercial banks can obtain cash if they need it. The RBA is cutting their cash rate because inflation is below their 2 - 3% target and without the cut would be well below that. Economic theory tells us there are a number of ways a fall in interest rates help boost Aggregate Demand (AD), the transmission mechanism of monetary policy. Theory also tells us that it takes 18 months to two years to have its full effect.

The question many are asking is 'will it work'? One mechanism by which cutting interest rates work is by discouraging savings and so booting consumption. However interest rates are already so low why would cutting savings rates discourage more saving? Households save for precautionary reasons as well as financial gain and it might be that most current savings fall into that category.

Another reason lower interest rates boost AD is that it is cheaper to borrow, encouraging both firms and households to invest and consume more. But is business and household confidence high enough for them to act on a small rate cut to a very low rate?

Low interest rates will also harm some members of society. Savers. The biggest groups of savers are retirees and those saving for superannuation fund. Retirees will find their income from saving will fall, and indeed the real value of those savings might fall as inflation exceeds interest rates paid. This will discourage consumption by retired households. Those who are saving for retirement might actually save more as they see the need for a bigger 'pension pot' for their future security. Therefore the interest rate cuts may act to reduce current AD.

The article below provides a survey of the situation and has some good short videos embedded. What is clear is that when interest rates are low cutting them further is like "pushing on a piece of string". While one end moves, the other end stays where it is. Lowering interest rates may have no effect on inflation or AD.

The Age article is here

VCE students need to know the transmissions mechanisms of monetary policy the study design identifies by name. Two or three mechanisms usually suffice. They should also know why monetary policy has been implemented as it has been since 2013. IB students need to understand the operation of monetary policy and be prepared to analysis and evaluate its effectiveness under different circumstances.

Regulating monopoly power - a good idea?

The European Commission has jut rules that there cannot be a merger of two of the four mobile phone network operators in the UK. They have done this because they say the reduction in competition this would involve could harm the interests of consumers.

There was a proposed takeover by the '3' network of the O2 network. The cost of the deal at nearly 13 billion Euros was enough to attract the attention of the EU Competition Commissioner.

The merger was banned because the EU feared that the result of having just three providers in the market would confer too much monopoly power on the remaining firms. They argue that prices would rise and the service quality fall as a result.

The reason that a high concentration ratio can be bad for consumers is the loss of efficiency that can result:

Productive efficiency falls because there is less competition and no need to keep costs low. There is also less incentive to invest in the service to improve because the chances of loosing market share is minimal.

Allocative efficiency is reduced as there is less need to provide consumers with an innovative new service and high quality as the alternative services are diminished.

Dynamic efficiency is reduced because there is less need to invest. An important point here is that the three remaining firms are more likely to act in their mutual interest and not compete strongly. It is not collusion, that is illegal, but a 'Nash equilibrium' becomes more likely. Each firm realising that strong competition is effectively cut throat they act in a way that maximizes mutual profit.

This is an excellent example of competition policy in action. Some will argue that banning the merger it is a bad move in the long-run as mobile networks need to become international, not national. That's a trade-off of long-run efficiency gains for short-run losses the EU is unwilling to make.

The BBC covers the story here

The detail of this story is of most interest to IB students studying market structures and government intervention. However VCE students should see parallels to the operation of the ACCC and the costs of monopoly power.

Rising student numbers and the exchange rate

There has been a large rise in the number of foreign students in Australia this year. This is in sharp contrast to the situation in 2011 when numbers plumbeted and Monash University offered 400 voluntary redundancies to its staff.

According to recent figures there has been a rise of 12% in overseas students in 2015/16 with the increase in students from China being a huge 23% higher than last year.

When this size of change occurs it is fair to say that something has changed in the market. It could be a change in a condition of demand or supply. However the turnaround in numbers has nothing much to do with extra places becoming available or a sudden jump in the reputation of Australian education.

The reason that Australia is a popular student destination again is all to do with the exchange rate. In 2011 the Australian dollar (AUD) bought US$1.1, today it will buy about 73 US cents. This makes it much cheaper for foreign students to study in Australia. The relative price of Australian educational institutions has fallen and so overseas students have switched from the alternative (substitutes) course.

The chart below shows the exchange rate of the AUD against the US$ since 2009.

The rise in student numbers is one example of how the competitiveness of the Australian economy has improved as a result of the depreciation of the Australian dollar. The result has been a boost to those sectors of the economy which reply on export markets, including manufacturing. As a result Australia is recovering from the end of the mining investment boom rather better than anticipated.

Business Insider provides details on the student numbers here

IB students will want to consider whether the Marshall-Lerner conditions are met and the ultimate effect on the Current Account balance. There will, of course, inevitably be a rise in the volume of exports and a reduction in the volume of imports.

This article is of great importance to VCE students as this is an important demand side influence on the Australian economy. IB students should also be equally interested in the article as an example of the impact of floating exchange rate regimes.

The 'Prepare - trial - hire' initiative aims to reduce youth unemployment

An important measure in the Australian Federal Budget is the so called PaTH initiative. It replaces 'Work for the dole' for young people (although that is available after a year of unemployment).

The PaTH initiative (it stands for Prepare, Trial and Hire) is a supply-side policy initiative to try to tackle the problem of structural unemployment among young workers.

Structural unemployment arises because of a mismatch between the skills workers have and the skills needed to fill job vacancies. Young workers have the disadvantages of no experience and no in-work skills. Training workers is expensive and is therefore a cost of employment. If the cost of employing workers can be reduced somehow then firms will hire more of them.

The chart clearly shows unemployment among young workers is higher than over 25's

The ultimate goal of this policy is to shift the Aggregate Supply curve to the right. The policy does this by increasing the supply of skilled workers. It does not assume that all young unemployed workers have no skills, but does assume that the lack of current skills means that some unemployed are not really employable and so not truly part of the workforce (or labourforce/labour supply) available to the economy.

The scheme works by paying the young unemployed  $100 a week extra on their benefits to take part in the early stages of the scheme. This is important because they need an incentive. If there was no additional payment the disadvantages of travel to work costs and getting up early each day etc. would mean many would prefer to stay out of work.

After the first two stages of the scheme employers receive help for six months to pay the wages of the young workers they hire - anothVCEer incentive. This is in addition to $1000 paid to firms at the early stage of the scheme. This payment, of between $6,500 and $10,000 helps offset the training costs of the new workers. With hope after six months of employment the new worker is adding more than the value of their wages to the firms revenue and will keep their job.

Will this work? We don't know until we try it. The incentives on both sides of the market have to be enough to fill the 30,000 places a year. It is clear not all 30,000 will go on to full time permanent jobs, but some should. Overall this measure should help to contribute to Australia's economic growth and lower unemployment. However it will do so only slowly.

The Age explains the scheme in detail here

This article relates to an important measure in the Australian Federal Budget 2016. VCE students need to know the details (plenty in The Age article). IB students can use it as an example of supply-side policy and should be able to analyse the effects in the AD/AS model.

Some reflections on the lowering of company profit tax

The Budget proposed lowering the rate of company tax to 25%. This is an example of supply-side policy and deserves some examination.

The first point to make is that the way this tax reduction is being implemented is getting some bad press. This is because the smaller the business the sooner the profit tax rate will fall. 'Small businesses' will enjoy the cut first, defined as companies turning over (have revenue of) $10 million. That's up from $2 million.

Over the next few years that turnover limit will gradually be increased to $1 billion. Some have chosen to ridicule the use of the term 'small business' in this context. Clearly that is irrelevant - this is a supply-side measure to encourage investment and so long-term economic growth.

The issue is that Australia now finds itself with a relatively high corporate tax rate. This means the incentive to make Australia your base of operation is diminished. And the problem has got worse since the Henry Commission on tax reform recommended dropping the rate to 25% in 2010, over the period many countries have dropped their company tax rate even further.

So the Australian profit tax rate has become far less attractive over the period 2005 to 2015. This may be diverting potential Foreign Direct Investment from Australia and is leaving Australian companies a smaller pool of retained profit to reinvest in their businesses. 

So the aim of the company tax cut is to improve the supply-side performance of the economy, raising the rate of economic growth (shifting the Long Run Aggregate Supply Curve to the right more quickly.

It is important to remember that supply-side policy is competitive too. Having a supply-side policy isn't enough, it has to be a policy that narrows the gap between you and the 'leader' otherwise they just get more competitive than you.

The Guardian looks more widely at tax and the 2016 Budget here

This article has equal relevance to IB and VCE students. VCE students need to know the detail of the tax cut exactly, but both groups need to understand the operation of supply-side policies.

2016 Australian Federal Budget

The 2016 Budget contains many measures and it is vital that VCE students are familiar with the major ones and the effect they have on the Budget outcome. The good news is that because there is about to be an election there are fewer new measures than usual. (However there may be a second Budget this year so this may be a short lived advantage.)

It is not possible to analyse the Budget in full in a blog. For now I am providing links to useful articles which can help you get to grips with the important measures and outcomes.

The first article from the ABC is called by them, a 'Cheat Sheet'. It provides important data on the Budget outcomes and provides estimates for economic indicators. It shows also the level of Australian National Debt compared to other countries and the changes to major expenditure programs.

A BBC article gives the main highlights of the Budget. Because it is a foreign publication the BBC only picks out the really significant announcements, so reducing the clutter. That does not mean you must not look at individual measures more closely - but this is a start. It sees the 'Google Tax' as the most noteworthy item.

Traditionally we look at which groups gain and which loose from a Budget. The ABC has an interactive page for you to check through.

The Age has a portal page to its full Budget coverage where you can find articles on the major measures in the Budget.

The chart below is from SBS. It shows the effect of 'Bracket Creep' (fiscal drag). That is as wages rise due to inflation compensating pay increases people start to pay a higher rate of tax because they move into a higher tax bracket. The graph illustrates how this has happened over the years. In this Budget there was a one-off rise in the 32.5% to 37% tax bracket threshold from $80k to $87k. A key question then is why not index link all tax thresholds every year automatically?

ABC Cheat Sheet is here

BBC Summary is here

ABC Winners and losers here

The Age Budget portal is here

This post is critical for VCE students who must know the measures included in this Budget for the exam. Try to classify measures by 'Demand side' and 'Supply side' measures. Consider the effects the measures will have on economic goals and understand the pressures which have led to those measures being implemented.

IB students can treat this as a case study in Fiscal Policy.

RBA custs the cash rate to new record low

The Reserve Bank of Australia (RBA) today cut the cash rate to 1.75% from 2%. This was most obviously in response to the recent very weak inflation figure, but actually is due to many factors. The statement by RBA governor Glenn Stevens pointed to a number of reasons but showed that downward pressures on inflation exceed upward pressure. These influences can be seen as demand side or supply side influences.

Downward pressure on inflation:

Demand side

* The global economy is continuing to grow, though at a slightly lower pace than earlier expected,

* Conditions have become more difficult for a number of emerging market economies.

* China's growth rate moderated further in the first part of the year,

* Uncertainty about the global economic outlook and policy settings among the major jurisdictions continues.

* GDP growth picked up over 2015, particularly in the second half of the year,  Indications are that growth is continuing in 2016, though probably at a more moderate pace.

* Credit growth to businesses has picked up over the past year or so.

* Appreciating exchange rate.

* Housing market, price pressures have tended to abate. 

Supply side

* The economy is continuing to rebalance following the mining investment boom.  

* Ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world. 

Upward pressure on inflation: (All demand side)

* Commodity prices have firmed noticeably from recent lows,

* Sentiment in financial markets has improved,

* Lower exchange rate overall has helped the traded sector.

* Credit growth to businesses has picked up over the past year or so.  

Although there are always opposing forces acting on inflation, when the pressure in one direction is significantly higher the central bank must change interest rates, The real question is why has the RBA waited so long to act. Interest rates take two years to work through the economy to affect inflation, so this might be too little, too late? 

It is probable that the RBA were concerned that low interest rates would cause house prices in Sydney and Melbourne to rise even faster. 

The RBA statement is here

 This post is of critical importance to VCE students who must be aware of and be able to apply all of the forces determining Australian monetary policy decisions. For VCE students the reasons that interest rates have been set is an excellent example of the application of monetary policy.

 

Budget jargon

There are going to be a few posts on the Budget and interest rates in the next few days.

Here is a starter - a list of terms that will be heard in the course of the Budget and its discussion. Look at the ABC article and click on the links.

The ABC jargon buster is here