Monday, November 29, 2010

Taxes and the cost of living

My friend David said, "This has bothered me for a while. Why don't taxes take cost of living into account? I am bothered that someone making the same I do that's living in the middle of nowhere pays the same as I do."

Months ago, I promised to respond. This is my response.

First I will examine the assumption David makes that taxes don’t take cost of living into account.

There are many kinds of taxes. Income taxes and sales taxes are the ones with which we’re most familiar, and I assume David’s comment was primarily about income taxes. But, do income taxes take cost of living into account? I think that there are two different kinds of arguments that they do:

1) Argument from progressive nature of tax code - Basically, the tax code allows for different sized deductions that do factor in cost-of-living. For example, mortgage interest income is deductible from taxes. Mortgage interest income is higher where housing prices are higher, and housing prices are a major contributor to overall cost of living. So, if you make $100,000, would owe $35,000 in taxes, but save $5,000 due to your mortgage, and then move to a more expensive place and start saving $10,000 due to a larger mortgage interest, then, in a sense, the net taxes you pay are 'including' the cost of living (at least the cost of housing). It's important that this deduction comes off the "top" of your income, because that means that the more you earn (until you are sufficiently far into the highest tax bracket), the more these deductions are "worth" to you.

Sales taxes are less progressive. The rate is the same for everyone. Still, though. where the cost of living is higher, the sales taxes are ALSO a larger amount in terms of absolute dollars. One way in which there is some progressivity is that the major purchase category for which sales tax is not charged (basic food items) constitutes a larger portion of the spending for lower-income individuals. Nonetheless, sales taxes generally exemplify David's statement. If you move somewhere more expensive, you pay more in sales taxes, even though it also costs you more to live in that place.

2) Argument from cost-of-living determining salary. Returning to income taxes for a moment, it is important to consider that income taxes are based on your salary. If it costs 10% more to live in a place, but you also get paid 10% more, in some sense the taxes should not "need" to factor in cost-of-living. To really do this calculation correctly, and be precise, you'd have to look at net taxes (because there are different rates and different deductions, depending on income), but in theory, this would work, and no further adjustments would be needed once you adjusted the salary to compensate for cost-of-living.

What this really means, as far as answering David's point is: "That person living in the middle of nowhere *doesn't* make the same amount as you." Let's say you earn $60,000 per year in San Francisco. That guy out there in Des Moines who earns $60,000 per year is probably one level higher than you in the corporate hierarchy. He's probably saying, "I can't believe this guy who's one level lower than I am makes the same amount I do!" If he said this, though, he'd be wrong, because his standard of living, at the same salary, actually is higher.

#2 brings up a tricky point in this whole topic - there are three independent levels of taxation: federal, state, and local. This makes it hard to figure out exactly what 'fair' means. Some taxes differ from place to place. Others (like most federal) don't. This does make it confusing because the 'local' part of a sales tax might be different in different locales, but the 'state' part might be the same. In fact, the 'wealthier' counties/cities, with higher costs of living, probably also tend to have the higher taxes. This, like all progressive taxation, is 'fair' in one sense and 'unfair' in another.

Taxes can be based on property, sales, use, business profits, value addition, income, or other factors. In each case, there will tend to be an extent to which these taxes automatically adjust for cost-of-living differences and an extent to which they don't. Sales taxes, for example, do a mediocre job of aligning with cost-of-living differences. Imagine two people, earning the same income, and buying the exact same stuff, in two different places. The stuff simply costs more in one place than another. The person in the more expensive place will pay more in taxes than the person in the less expensive place. Property taxes are similarly mediocre. Property taxes punish people where values of assets are going up and reward those where values of assets are going down. Income taxes and corporate profit taxes (which are similar in their function and structure), probably do a little better job of adjusting for cost-of-living differences, but are still imperfect.

One more complication is to look at the usage of services. A big city might use more or less services, per capita, than a small town. The cost of providing a sewer, for example, is lower in a big city than in a rural area per capita ceteris paribus. Therefore, the taxes paid for such a thing should be lower. In reality, though, because the land used to build a sewer system is so much more expensive in the city than the country, taxes end up being higher in the city despite the fact that the cost of living (to which the cost of land is a contributor) is already higher.

Finally, there is another point I should make. For the most part, I think incomes adjust for costs of living, and so income taxes don't need to. But there are places/instances where taxes and costs-of-living are out of whack. We still have to ask ourselves, though, if we should do anything about it. Let's say that in some sense, David's situation is 'unfair' and he pays a 10% penalty for living in a certain place. We could change this, by lowering the taxes in that area to compensate, but that would just make the problem worse (even more people would flock to this magical place, driving costs up further). So, instead, we must trust the market to solve these problems. What David should do is demand more income from his employer to cover the taxes. If they refuse, he should move. Eventually, this will force companies to locate where the cost of living is lower.

Wednesday, November 24, 2010

Pelosi

Nancy Pelosi is the epitome of what's wrong with politics. She's a pure partisan who cares only about "winning" and doesn't care about actual policy-making goals. She understands little about economics, international relations, history, sociology, or government.

This article is just the most recent example of her continual partisanship. If she was a real partisan because she had some ulterior motive, which was ideological, I might be able to forgive her. But she doesn't have such a goal. She isn't even an ideologue. She doesn't believe in ANYTHING. She just thinks her job is to get elected as many times as possible and get as many other people on her "team" elected as possible. THAT IS NOT THE GOAL.

This article basically says that her new goal is to keep the president from compromising with the Republicans. With the Republicans in control of the House, how is anything going to get done without a compromise? Oh, wait, Pelosi doesn't care about getting things done - she only cares about winning. The Obama White House didn't exactly take the most conciliatory approach or bipartisan stances, yet Pelosi believes they did too much compromising.

Tax legislation, for example, must originate in the House. So, how are we going either make any deal about the tax cuts without a compromise between the House and the President?

Pelosi is worthless and should retire from politics before she destroys the Democratic party, which is clearly floundering under her "leadership."

Tuesday, November 23, 2010

What's Going on in Korea?

What is going on with the two Koreas?

Events leading up to today

There are many events that go on, including abductions of S. Koreans and others, as well as frequent near-skirmishes between the militaries of North and South Korea. Here are a few selected, and hopefully relevant, issues that have come up recently:

Since the 90s, at least, N. Korea has been working on a variety of nuclear weapons programs. All attempts by the US and others to stifle (or even identify) all such programs seem to have failed.

From about 1998-2008, S. Korea pursued what is called the “Sunshine Policy.” This was a policy of accommodation and rapprochement with N. Korea. It seemed, at times, to be succeeding, when economic or social ties between the two countries improved.

Before, during, and after the Iraq War, the US reduced the number of troops in S. Korea by about half. Removing troops from the border area is often considered an aggressive move, because the troops are within range of N. Korean artillery. It was generally believed that if the US were to seriously attack N. Korea, the first thing it would do is remove troops from that area before commencing massive bombing of the North. The Iraq War provided a good excuse to remove troops because they were needed in the Middle East.

North Korea appears to have tested a crude nuclear device in 2006. It is unclear to what extent they had integrated such capability with a delivery mechanism (such as a missile).

In 2009, N. Korea again tested a nuclear device underground, as well as several missiles. It is still unclear to what extent they have been able to weaponize a nuclear device.

In March, a S. Korean warship was sunk by an explosion, killing 46. Several reports later concluded that the explosion was caused by a N. Korean torpedo.

In late September, Kim Jong Un, son of Kim Jong Il, was designated as the next leader of the country. Some felt there was internal dissent or tension at this time, possibly between factions within the military.

Last week, N. Korea revealed a previously undisclosed uranium-enriching operation. The equipment was modern and recently constructed.

In general, winter is a hard time in N. Korea. The economy there struggles to produce enough food, energy, or medical care to take care of its people. Frequently, especially in the winter, the North is dependent on food, heating oil, and medicine aid from the US, Japan, Europe, China, and S. Korea. In recent years, deals for such aid were often struck at the “Six Party Negotiations” between China, the US, Russia, N. Korea, S. Korea, and Japan.

No serious reaction from S. Korea or the US over the torpedo attack or the uranium enrichment has been made public (and probably, nothing had yet really occurred). The Six Party Talks are not currently underway and the US has made cessation of nuclear activities a precursor to resuming them. N. Korea has requested direct, bi-lateral negotiations with the US, which the US has refused.

Here is a more thorough timeline: http://www.nytimes.com/info/north-korea/news/.

Today’s events

The events that unfolded today actually started a couple of days ago. South Korea regularly does large-scale military exercises near North Korean waters. Some territorial waters are disputed. S. Korea generally has the better, if not airtight, claims to these waters in the eyes of the international community. Although invited to participate, the US was not involved in the recent exercises. The North asked South Korea not to use live ammunition in the exercises, but the South did, anyway. The South was generally firing away from N. Korea (from north to south). A few days ago, N. Korea seems to have requested that the exercises not occur (or perhaps again that they not use live ammunition). The South seems to have ignored this request. In fact, the South continued the exercise and fired some shots into a region of ocean to which N. Korea disputes S. Korea’s claim. There were no N. Korean targets there, just disputed water.

Today, N. Korean artillery began shelling an island near N. Korean waters. The island has both civilian and military structures and people on it. Two S. Korean marines were killed and some civilians and soldiers were injured. South Korea returned artillery fire and launched aircraft which apparently struck targets in N. Korea. Information about the extent of the damage or casualties in N. Korea doesn’t seem to be available. After an hour or two, both sides stopped firing and S. Korea began evacuating people and putting out fires on the island. Their military remains at the highest alert.

Why did they do it?

The first interesting question is what motivated this attack, which was a clear escalation. Complaining about somebody else doing live-fire exercises and shooting at civilians’ houses are obviously very different “levels.” It is almost impossible to understand the motivations of the N. Korean regime, which don’t always seem consistent, let alone understandable, predictable, or rational. I believe there are several possibilities for explaining N. Korea’s blatant escalation today:

1) The North believed a return to the Six Party Talks was imminent, perhaps over the uranium revelation, and is trying to gain some kind of advantage in the negotiation. If you create a problem, you can offer “stopping the problem” as a concession in negotiations. I don’t know that this strategy would work, but the North seems to have used it before.

2) They are trying to force a return to the Six Party Talks before the cold of winter deepens, perhaps because they believed that the West was going to “let them starve” this winter. Perhaps, behind the scenes, the US was already threatening N. Korea with something and this is their way of “changing the equation.”

3) The new leader is being given some sort of opportunity to ingratiate himself with the military or prove himself to the military.

4) Because of the weak response or lack of response to the torpedo incident and the uranium facility revelation, perhaps the North is overconfident. Perhaps they believe the US and S. Korea don’t have the will to respond and the N. Koreans are simply pushing the envelope.

5) There is internal division in the North, and an aggressive or militant faction is testing its ability to act independently from the leadership.

6) There is a lack of command and control in the North, and soldiers accidentally escalated a situation without the permission of the leadership.

What must S. Korea and the US consider in response?

It is very difficult for the US or S. Korea to respond. There are several considerations:

1) The US cannot allow provocations like this to go unanswered, because it seriously undermines alliance with S. Korea and Japan and casts doubt upon America’s ability to defend its allies. It risks emboldening China to use (or continue to use) N. Korea as a proxy bully to influence S. Korea and Japan while diffusing blame away from itself.

2) Any military response risks further escalation. Tens of millions of S. Koreans are within range of N. Korean weapons on the border. N. Korea has a huge, standing army.

3) China has not been willing to enforce any serious sanctions on N. Korea.

4) Everyone seems worried about internal stability in N. Korea, and whether there is some sort of struggle going on there, as well as what would happen were the leadership to fail or be removed.

5) N. Korea may have a nuclear device that can be “fired” or “launched.” No one is quite sure. It is unclear whether the US knows where such devices are and could pre-emptively destroy them. Given that we can’t find the enrichment facilities, it seems unlikely we could pre-empt such a launch. Such a device could probably only reach S. Korea, but possibly Japan.

Andy’s recommendation:

There must be a serious response and it must take China into account. We must break the pattern of letting N. Korea provoke the world, then negotiating, then giving away carrots in negotiations. That pattern encourages continued aggression. We must also somehow punish N. Korea without escalating the military situation if possible, and without causing an all-out war.

In many ways, the ideal response would be a total blockade of the North. This would again re-balance the negotiating positions. In eventual negotiations, the US would then be offering simply to stop blockading the North, rather than offering it incentives to stop attack S. Korea. However, the North has previously claimed they would consider this an act of war (they have to say that, for obvious reasons), and China has never honored such a blockade. China is the biggest trading partner for the North. Even if such a blockade were to succeed, millions of N. Koreans could die from cold and starvation.

Therefore, I believe the US should pursue a multi-pronged strategy:

1) The US should declare a partial blockade of N. Korea and should move an aircraft carrier East of of Japan. It should pledge to board and search all ships entering N. Korea under the non-proliferation initiative framework to check all cargo for contraband. It should reserve the right to refuse passage to any or all ships into N. Korean waters as well as to seize any cargo meant for N. Korea. It should not necessarily enforce this blockade, but should set up the infrastructure to do so. All aid shipments should be suspended.

2) The US should signal consideration of committing an additional $1 trillion to missile defense programs over the next 20 years. It should signal that these missile defense systems would be designed to protect Taiwan, Japan, and S. Korea, and that such systems would be designed to “destroy all missiles launched from the region, including all nuclear missiles.” It should indicate that such programs could still be cancelled.

3) The US should immediately propose to sell the Aegis weapon system to the navies of S. Korea, Japan, and Taiwan to “promote regional safety and stability.”

4) The US should immediately request that India be added to the UN Security Council.

5) The US should also immediately pledge $10M (a token amount) to promoting “democracy and freedom of information in Asia.”

6) S. Korea should immediately pledge “support to Google, Microsoft, Yahoo!, and other American, Japanese, and S. Korean internet companies” to provide a haven for search engines, internet media, etc. in S. Korea from which to “serve Asian users.”

7) S. Korea, Japan, and the US should immediately announce new rules requiring any acquisition of any American, Japanese, or S. Korean company by any Chinese entity must be reviewed by the respective governments.

8) The US should tell China that it must publicly denounce the N. Korean attacks and announce public support for the Six Party Talks to resume.

9) The US should propose a resumption of the Six Party Talks.

10) The US should explain to China that many of these provisions can be reversed, and should agree in private with China on whether to back a coup d’etat by the military in N. Korea, should one occur.

11) The US should announce that if a “peaceful actor” were to change the regime in N. Korea, the US would recognize that entity as a new government and would lift the restrictions on N. Korea.

12) The US should move a token number of troops (perhaps 500) away from the Korean border. It should claim that they are being “redeployed” for “security reasons.” It should announce that it is contemplating further “redeployments.”

13) The US should immediately order Patriot-missile-type systems as well as other defensive weapons moved to S. Korea “sometime during 2011.”

14) The US should propose replacing SEATO with a new organization, complete with a true mutual defense pact, to include the US, UK, Japan, S. Korea, Taiwan, Australia, and India. It should propose placing its remaining troops in Japan and S. Korea under the command of this body, which would operate much the way NATO does. It should gain commitments totaling 40K troops and many naval assets from the other countries. It should set a timetable for building up such an organization’s capabilities by 2015. The US should further propose that a broader organization, to include Pakistan and other SEATO members, but without the mutual defense pact, also be created.

In all cases, these are measures which could be negotiated away but which would, if not negotiated away, actually be pursued. I believe these measures (or measures like these) strike the right balance between punishment and escalation, while pressuring China, but don’t give enough provocation to the North for it to escalate the military attacks.

Monday, November 08, 2010

GDP in Q3 (2011)

The Tutorial

Below is an analysis of the US GDP numbers for Q3 as well as a tutorial on reading these charts.


The chart I like the best is the one that shows contributions to percent change in real GDP. First of all, it's inflation-adjusted. That takes care of one variable. Second, it's broken down into the units and terms we're used to. We normally think of GDP in terms of the annualized % growth rate. Saying the GDP grew 1.7% in Q2 means that the rate the economy was growing during Q2 would result in the economy being 1.7% larger after one year. It's kind of like talking about credit card interest rates or loans in terms of "APR." It's a standardized measure we're accustomed to interpreting.

The US GDP grew at a rate of 2% in Q3'11. This isn't 2% before inflation, it's 2% after inflation. If inflation was 3% (annualized rate), it means that the absolute GDP growth rate would have been 5%. Remember, too, that the GDP didn't grow 2% in Q3. It grew at an annualized rate of 2%. If that growth was spread out evenly over the year, that would mean that it grew about 0.5% during Q3.

GDP is calculated as the value of all goods and services produced in three sectors (consumers, business investment, and government) +/- net foreign trade. The reason why you have to add or subtract foreign trade is that otherwise, if we produced more, but sold more overseas, it would look like our economy hadn't grown, even though it had. Similarly, if we bought more outside the US, it would look like we had produced things which we didn't (someone else produced them and we bought them). Remember, GDP is a measure of production; even if parts of it are calculated my measuring consumption. It's not a measure of the amoung of wealth saved up in bank accounts or a measure of consumption. It's also only sort of a measure of how much we've really invested. The GDP is broken down into durable and non-durable components, but these breakdowns don't tell the whole story. We could build 100,000,000 tractors and the GDP would seem really good for one quarter, but the long-term quality of this investment strategy is questionable at best. The way this chart works, if you add up the contribution from consumption in Q3 (1.79), the contribution from investment (1.54), and then the contribution from government (0.68), then add a negative (2.01) (for foreign trade), you get the overall annualized rate of 2.0%.

Breaking the numbers down in this way helps one understand the numbers enough to make use of them. Let's say you work at a company that paints office buildings. These paint jobs are durable goods and services. They are things which would contribute to the 1.54 contribution from investment. Here is a chart that shows the breakdown of the US GDP by sector. This shows NOT how much each sector contributed to the growth in the GDP, but simply how big each sector is. Notice how the investment component is fairly small. Business investment makes up only perhaps 10-15% of the total GDP. This means that the 1.54 contribution is REALLY LARGE. Over 3/4 of the total net growth in GDP was attributable to the private investment sector (which is nearly all business) despite the fact that that sector is only about 1/10 of the overall economy.

So, if you're an office painter, you might think, "Wow, great. That means that my industry is booming! I might have lots of new customers!" A deeper look, however, dashes these hopes. Let's look at the breakdown of the Gross Private Domestic Investment component. Of the 1.54, 1.44 is just a change in inventories. Our painter now seems less optimistic. Only 0.10 of that 1.54 is made up of investment in "Structures" which are the things he paints. The painter might take some solace in seeing that inventories are up, though, and think, "Maybe stores will be trying to get rid of inventory and now is a good time to stock up on paint!" And indeed, that might be a good idea. He would need to look at a more detailed breakdown to see how much he could learn about the inventories for paint in particular (because, again, it might be that while inventories are up in general, they aren't up among paint manufacturers or vendors).


Technical note: In general, if you want to see if a contribution from one area is large relative to another, you must "normalize" them by a) dividing the contribution from a sector by the total GDP growth, and then b) comparing this to the percentage of the total GDP which this sector comprises. Where (a) yields a larger number than (b), you've identified a sector where growth was relatively fast.

My Analysis

I apply the above process to the GDP across all the different components, and I look for things that stand out. Here is the summary of what I see in the Q3 2011 numbers:

Imports: The imports number in Q2 was a HUGE drag on the economy. In Q3 it's not dragging the overall number down as much, but it's still significant. We're importing a ton of goods, and a lot less services. This is pretty important, because it means that if you're an a service industry, the relevant parts of the GDP might be "growing" faster for you than in general.

Personal consumption: This is, by far, the largest sector of the economy, and it posted its best number (by % contribution) of the last 11 quarters.

Exports: Exports grew during Q3'11. This is not intuitive, because net foreign trade contributed negatively to the overall GDP growth. But, exports grew. Imports just grew more quickly. This is really important because if you're generally a company that, say, helps exporters, your likely pool of customers grew. Just because there are more importers doesn't mean there are less exporters.

Sellers of "goods": If you work for a company that sells TV's at Best Buy, these numbers are so-so. You don't really care too much about imports and exports, because it doesn't really matter to you where the stuff at Best Buy comes from, you just want to know if retail sales are generally "strong" or "weak." Personal consumption (much of which is sales at retail), here, is a fairly strong contributor. However, much of this positivity comes from services, not goods. Non-durable goods make up about 16% of the overall GDP, and account for about 10% of the growth in GDP.

Government: State and local governments make up about 59% of the whole government sector in the country. This number has actually fallen, as local governments have laid people off and the federal government has spent massive amounts of money to stimulate the economy and run huge, huge deficits. As recently as 2008, local and state government accounted for 63% of all government spending. Many years ago, as much as 70% of government was state and local. The shift from state and local spending to federal spending is good and bad. From the standpoint of suppliers to the government, it means fewer, large, centralized contracts. It may also mean more jobs in Washington and less jobs in Columbus, Lansing, and Albany. Generally, when the economy is growing and yet the government sector is shrinking, that is a really good sign for businesses and long-term prospects. It means that manufacturing and trade activity are flourishing.

Connection to jobs: Many, many things influence the growth of jobs in the country. The GDP doesn't tell the whole story when it comes to jobs. But, it does provide a starting point. If the GDP is growing, economic activity is growing. Usually, this leads to jobs being created (sometimes with a lag). However, the population of the country is also changing. People immigrate and emigrate, they age and die. New people are born. It is overly simplistic, but if the country's population is growing 2% per year and the real GDP is growing 2% per year, one might expect the unemployment rate to stay constant (because there are just as many new jobs being created as there are new job seekers). This type of analysis is very crude, but it is consistent with what we're seeing today. If we just looked at consumption, investment, and government, we would see a GDP growth rate of 4.01%. That's roughly equivalent to the rate that we're "consuming" things. However, half of that consumption "growth" is being supplied by foreign producers. Thus, not very many jobs in the US are being created. It's tempting to think we should, therefore, stop imports. This is wrong and usually doesn't work, but it seems intuitive. Remember, though, that stopping imports isn't what matters. Increasing exports creates jobs. Ceasing imports doesn't create jobs, it just makes things more expensive. We should try to grow exports, consumption, and investment. Those are all drivers of jobs. We should grow government where it's efficient, but the overall size of government is probably already big enough. Government is generally less efficient than private industry, and it certainly lags behind private industry in two important categories: 1) making smart investments, and 2) creating productivity-enhancing technology.

Summary: In summary, the GDP growth numbers are mixed. The economy is growing, but it's not growing fast enough to create a lot of jobs. Some of that growth is government, which isn't as sustainable in the long run as other kinds of growth. No one sector, right now, is horribly under- or over-performing. An overall growth rate of about 3.5% is a much more healthy level. Hopefully we'll reach that kind of rate again in another quarter or two, but I'm not holding my breath. I think we may be in for several more quarters of lackluster 1.8-2.8% growth.