Wednesday, 25 March 2009

The Financial Crisis and China

By John Humphrey
Expectations about the impact of the financial crisis in China seem to have gone through three phases. The first was optimistic, suggesting that China had become more delinked from the global economy and less dependent on exports. The second was more pessimistic, driven by the realisation last year that there were very substantial declines in Chinese exports. There were estimates that as many as 20 million people lost their jobs in the heavily export-oriented cities of the coastal South. The third phase, which has just become evident, is a view that there will be a slowdown, but not a crisis. The IMF has reduced its prediction of growth in the current year to 6.5%, but this is still good by global standards, even if half the rate of a couple of years ago. In part, this cautious optimism is the result of government measures to stimulate the economy by promoting infrastructure spending and rural incomes.

There has been a dramatic fall in imports into China, particularly from the East Asian region. As China's exports fall, so does demand for the imported parts and components that are incorporated into the export product. However, rather sensational data showing drastic year-on-year falls in imports may overestimate the problem. First, the overall level of imports must have fallen in part because of the decline in commodity prices in 2008. We need more data on import volumes as well as values. Second, there might well be a short-term de-stocking tendency. Demand for Chinese products in the United States and Europe fell sharply last year. As it takes time for products to reach these markets, retailers will suffer over-stocking as deliveries are maintained at previous levels for some time after sales start to fall (or in the case of garments, they may pile up in the warehouses of suppliers in Europe and the US). Faced with excess stocks, retailers not only cut back orders to reflect the new lower level of demand, but also compensate for the excess stocks that have built up. The same effect happens to assemblers in China. They carry on producing, experience a decline in orders and then reduce production to compensate for both over-stocking and lower demand. They, in turn, go through the same processes with their suppliers. If this effect really does occur, it means that short-term falls in imports of components could be much greater than the medium-term equilibrium level of production and demand during the crisis.

Tuesday, 24 March 2009

Tax Policy, at Last!

By Xavier Cirera

I am delighted to hear that the US House of Representatives is considering levying a 90% tax on bonuses paid to employees with incomes above $250,000. I even think that the proposal falls short; for those working in institutions being rescued with taxpayers’ money, the tax should be large enough to make the bonuses equal the amount they would be receiving if they were on unemployment benefits. But most important is that this news represents a very good opportunity to raise the forgotten issue of tax policy.

The current crisis has clearly exposed that incentives in the financial sector are largely distorted to obtain short run profits, jeopardising long run sustainability of financial institutions. The blame so far lies on risk models and lack of financial supervision. However, this omits a well known fact that one of the most important tools of governments for curbing incentives is taxes. Any standard economics textbook very clearly shows that when the social costs of an activity exceed the private costs of agents engaged in that activity, this should be taxed to equalise private and social costs (i.e. the pollution case). On the contrary, we have seen how, in the financial sector, incentives (bonuses) have been taxed mainly at capital gains tax rates, which are lower than the income tax that most households pay with much lower income levels. This is just an example of how taxation policy has been ignored for many years.

The omission of taxation from economic policy has not only affected financial sector incentives. Domestic taxation remains a serious constraint for developing countries’ growth, which tends to have a small income tax base. Efforts have been made to implement VAT schemes in many LDCs. Nevertheless, advances on direct taxation remain very modest. Many developing countries rely mainly on trade taxes and taxing a few firms in the formal sector, and some of these taxes can be quite distortive.

The positive link between tax and the quality of governance (pdf) is well documented (example by IDS colleague, Mick Moore). The question is then why tax policy has ranked so low in donor policy agendas. Even the IMF, in charge of policing fiscal deficits, has put far more emphasis on disciplining expenditure than on achieving a sound and diversified tax base. In addition, as Adrian Wood suggests , it is likely that aid flows have undermined any incentives for governments to prioritise the increase in tax revenue.

Whatever the reasons are for the marginalisation of tax policies from economic policy agendas, let’s hope that the current crisis pushes taxation back on the development agenda. Taxation is not only important for equity, but also for efficiency and growth.