Bryan Caplan  

Singapore: "Automatic Stabilizers" Done Right

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Elasticity Bleg... Tone of Comments...

Tax cuts are a popular cure for unemployment, but there are strong reasons to doubt that they are a good way to achieve this goal. As I explained a while back:

Where does the money come from? If the central bank prints up $1000 and the government uses it to cut taxes, spending goes up; but that is monetary policy in disguise. The interesting question is: What if you raise spending (or cut taxes) and hold the quantity of money constant? The basic possibilities:

1. You raise spending by raising taxes. This seems like a wash for total spending. (There is a sophistical argument about the Keynesian multiplier that says otherwise, but I won't bother with it here).

2. You raise spending by borrowing. Again, this seems like a wash for total spending. If the quantity of loanable funds stays the same, the government borrows more and the private sector borrows less. If the quantity of loanable funds goes up because of higher interest rates, the government borrows more and the private sector consumes less.

3. You raise spending by printing money. Oh, wait, we ruled this out by assumption.

(Alex Tabarrok concurs; for a contrary view, see Mankiw; here's my reply to Mankiw).

Imagine my surprise, then, when I discovered that Singapore has figured out a stunningly clever way to use tax cuts to reduce unemployment. Instead of focusing on stimulating demand, Singaporean tax policy hits the margin that matters: labor costs. When there is a surplus of labor, they cut employers' share of the payroll tax (known in Singapore as the CPF). Details appear in Henri Ghesquiere, Singapore's Success:

The government directly intervened to temporarily lower the cost of business in Singapore through... its power to lower the CPF contribution rate of employers...

Elsewhere, substantial nominal currency devaluation is often the last and only resort in the face of downwardly sticky nominal wages, often with higher inflation as an undesirable side effect. In contrast, Singapore uses the direct intervention methods at its disposal. In addition, there is built-in wage flexibility, because an important portion of workers' remuneration is automatically lowered if GDP falls short of target.

With flexible wages, of course, it doesn't matter who legally pays the a tax. But the whole problem with recessions is that wages are somewhat sticky - you can have surplus labor for years before wages fall enough to restore full employment. By cutting employers' share of the tax, the Singaporeans greatly speed up the wage adjustment process.

We should expect the Singaporean system to work very well. Suppose we conservatively assume that labor demand elasticity is only -.4. Then a 1 percentage-point cut in employers' share of the payroll tax will roughly increase employment by .4 percentage-points. With a more optimistic elasticity of -1.0, every percentage-point cut in taxation would raise employment by 1 percentage-point. This approaches the Lafferian dream of tax cuts that fully pay for themselves. (In savings-obsessed Singapore, unsurprisingly, they also raise the payroll tax during booms).

Non-economists may have a hard time appreciating the genius of the Singaporean policy, so let me spell it out. If you want to change behavior, the smartest approach is to change the price most directly relevant to that behavior. If you want to cut carbon dioxide emissions, the smartest approach is not to start spending money like a drunken sailor on anything vaguely related to carbon dioxide. The smartest approach is to raise the price of emitting carbon dioxide. Similarly, if you want to reduce unemployment, the smartest approach is to reduce the price of labor. By cutting employers' share of the payroll tax, Singapore does precisely that.

Question for Discussion: What would happen in the U.S. to a politician who proposed a tax cut for employers to reduce unemployment?


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COMMENTS (14 to date)
mgroves writes:

Answer: the same thing that happens in the U.S. to a politician who proposes *any* tax cut. He is wrongly criticized for helping only the weathly and contributing to national debt.

(Though I imagine democrats would get a free pass for proposing tax cuts. If that happened, though, I wouldn't notice because I would be too busy selling ski trip vacations to hell).

John Smith writes:

I am a Singaporean Undergrad student.

Correction: The CPF is not a payroll tax. That is somewhat inaccurate. It is the portion of the employee's pay which the govt holds in trust for the employee until he is of retirement age. While it functions much like a tax, the distinction is that the legal ownership of the money is with the employee, the govt only takes over temp control.

Another issue is that this effective method is rather unpopular thus it can only be used by a govt that is strong. A democracy like the states is unlikely to accept such a method.

Matt writes:

The CPF is the equivalent of our social security system. It is an enforced monopoly retirement bond system.

Therefore, if workers take some retirement out to compensate for a cyclic reduction in wages, that is a good thing; and would normally be acceptable (with some penalty?) in a privately run retirenment program.

So, I give the Singaporean socialists credit, in this instance, for running a socialist program more like its private sector counterpart.

TGGP writes:

The main weakness in this mechanism is that I have never met anyone who has adjusted his cash holdings when the interest rate changed.
Anecdotal evidence is weak. How about some data on elasticity?

TGGP writes:

Whoops, I guess that comment should be for your post on fiscal policy.

Rich writes:

I'm a longtime reader and admirer -- thanks for the posts and the book. I think that there's a problem with the elasticity calculation above. The payroll tax in Singapore is approx 30% of pre-tax income (I think the figure is 3/11 from cursory googling but if someone has better figures pls correct). A reduction in payroll taxes of 1% of wages will, if the elasticity is -1, increase hours worked by 1%. However the payroll tax will have gone from 30% to 29%, therefore the tax rate will have been reduced by 3 1/3%, so net revenues will decrease by 2 1/3%.

Gary Rogers writes:

There are three separate issues here and all three are important. First is how you pay for tax cuts, second is what taxes should be cut, and third is what you do after the tax cuts have run their course. The fact that Singapore appears to be targeting the correct taxes does not change the fact that there are consequences from the way they are financed, though, according to John Smith it sounds like the Singapore policy is self funded out of the retirement funds of the workers. It also appears that the Singapore policy is to bring taxes back to their original level once unemployment is reduced.

In our case, we chose to fund tax cuts using the second option:

2. You raise spending by borrowing. Again, this seems like a wash for total spending. If the quantity of loanable funds stays the same, the government borrows more and the private sector borrows less. If the quantity of loanable funds goes up because of higher interest rates, the government borrows more and the private sector consumes less.

The interesting thing about our situation is that our own savings rate is so much lower than the countries that we import from, that we end up borrowing from our customers. Consequently, the consumption that is reduced is the consumption of our exports. It is not only an erosion of national wealth, but it reduces our long run competitiveness. Without understanding this, the tendency is to blame our trade imbalance on an "uneven playing field" and try to solve the problem through limiting imports. This only makes the situation worse.

As far as targeting the right things for taxation, I think our biggest mistake is using taxation to encourage spending and discourage savings. With the recent predictions of recession, there has been too much talk about how we can keep the economy moving by encouraging consumers to keep spending. Although this would be good policy if consumers had been saving through prosperous times, it is not an option when consumers have already borrowed to the limit. Our past policies have effectively limited our options to deal with today's problems. If we were generally on the right track we could fine tune our tax policies to target unemployment or even CO2 emissions, but right now we have bigger problems.

Good post Bryan!

John Smith writes:

Regarding Matt’s comment, he is incorrect in assuming that the retirement funds can be taken out by citizens merely by accepting a penalty. The funds cannot be taken out under any situation (to the best of my knowledge, which is high) at all. CPF is not similar to your IRA. The only way you can take any money out is to attempt to defraud the govt through some moderately complex paperwork, which is fairly well-known and therefore risky. The govt assumes near absolute and total control until the citizen reaches retirement age. The citizen’s sole discretion, as far as I am aware, is to select the investment choices.

Regarding Rich’s question, it used to be 40%, half of which is each borne by the employer and employee. Currently, I understand that the employer’s share to cut to around 10+%.

Once again, it is not a tax. It is a compulsory retirement scheme enforced by the govt. Imagine a world in which Uncle Sam passes a bill forcing every employee to contribute 20% and their employer 13% to the employee’s IRA. That would be more accurate.

brian writes:

mgroves writes:

(Though I imagine democrats would get a free pass for proposing tax cuts. If that happened, though, I wouldn't notice because I would be too busy selling ski trip vacations to hell).

Ahh, but remember that Democrats do propose tax cuts, but the media doesn't really harp on them. For example, Obama is campaigning on a tax cut, as did Gore in 2000.

Unit writes:

During the Italian elections in 06, Prodi pledged to reduce the "cuneo fiscale" (fiscal wedge) by 5%: this is the difference between what employers pay and what employees get. Two years later, it seems very little has been done in that direction.

JimSaco writes:

Any proposed reduction in the payroll tax for employers only would be relentlessly demogogued by the Democrats as a giveaway to "rich corporations".

It'll never happen.

Unit writes:

I take it back. This is what the new 07 (financial) law says in Italy:

Employers in the Center/North can deduct 5000 Euros per new employee that is hired "with tenure" (i.e. not those who are hired for a specific length of time). In the South it's 10,000 Euros. Also higher deductions are possible when hiring women, these depend on the local rate of unemployment and can be as high as 140,000 Euros.

On the other hand, under Prodi, the total share of GDP represented by tax revenues continues to grow and I think it is now around 43%. If only they could reduce spending....

Sam writes:

To John Smith:
"Once again, it is not a tax. It is a compulsory retirement scheme enforced by the govt. Imagine a world in which Uncle Sam passes a bill forcing every employee to contribute 20% and their employer 13% to the employee’s IRA. That would be more accurate."

Wait a minute - the magnitude may be different, and the employee may have discretion over investment choices, but isn't this like Social Security but better (Its defined contribution)??

We already pay payroll taxes into the SS fund. So Uncle Sam has already passed a bill forcing every employee and every employer to pay into a pension fund - the only difference is its defined benefit - if with potentially fluid (read reduced) benefits.

John Smith writes:

To Sam:

the amercian social security is nothing but a legal fiction. totally meaningless. there is no relation between revenue and expences at all.

our cpf on the other hand is a fully funded substainable and efficient retirement system. not that there are no drawbacks, mind you. but miminal.

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