Most popular posts of 2015

Blog posts were not as frequent as I would have liked this year. But I did gain a much wider audience with some of the more popular posts that were widely cited. I'm proud of them. I hope my readers found some valuable insights in there somewhere. 

If you want to indulge your economic curiosity over the holiday period, here are the top ten posts of the year for your reading pleasure.

1. Improving 'Neoclassical man' with a gaze heuristic

2. Macroeconomics = Fallacy of Composition

3. Back-scratching: Do what's best for your mates and screw the rest

4. Adam Smith’s Pin Factory: Capital vs division of labour

5. The confused economic orthodoxy

6. Uncertainty and morality in a dynamic economics

7. More unpopular economic opinions

8. Unpopular economic opinions

9. Dodgy rezoning, a summary

10. How to analyse housing markets

Humans vs Houses: Australia's perverse tax system

Investment property income beats working
I often joke that my investment property earns more than I do. Thinking more about this led me to the realisation that my investment property has an privileged position in the tax system when compared to a measly old human.

Below I summarise some of the main tax considerations from the perspective of being a human making wages, or from the perspective of being an investment property (the property owner).

After making this comparison, our current system appears to be designed exclusively for the betterment of the property community, rather than the people community. It’s unreal. The whole thing is back to front, with all that green showing investment property to be a clear tax winner.

Let us take a closer look at the marginal effects of a dollar increase in income for a one-income family, with two school-age children earning $100,000. They are an above-median household, and a prime candidate property investor. You know. To secure the children’s future. We’ll call them the ‘Battler’ family, because in Australia if you aren’t on the property ladder, making money is a battle.

An extra dollar in wage income for the Battler family over a year attracts income tax, along with a loss of family tax and medicare benefits that together account for 60c of that extra dollar. So 40c in the pocket. The graph below, from David Plunkett, shows the effective marginal tax rates (EMTR) for this family currently in Australia.

Let us examine the case when the Battler family instead makes their extra dollar from capital gains on their investment property. Using round numbers, they buy a $500,000 home with an annual rental income of $20,000, and annual rates, maintenance and other costs of $6,000. They finance this purchase with an interest only loan attracting a $25,000 annual interest bill.

They make a loss of $11,000 over the year they own the property. Of that loss they are out of pocket only $4,400, because they have reduced their taxable income and avoided $4,000 in tax, and gained $2,200 in family tax and medicare benefits.

After one year they sell with a price after selling costs of $511,001, making $1 net over the year from the property investment project.

It’s a risky way to make $1, compared to getting a rounding-error sized pay rise. But we want to compare dollar-for-dollar the tax incentives for earning wages or earning capital gains though property speculation.

So what did the battlers get out of their $1 gain from property investment? First we factor in the 50% capital gains tax discount because they owned the property for more than a year. So they only need add $6,500.50 of the capital gains to their taxable income. With a 60% EMTR that means they keep $9,100.20 in the hand (the tax-free $6,500.50 half, plus 40% of the remaining $6,500.50).

Subtracting last year’s net loss of $4,400 gives a total net gain of $4,700.20. I summarise how this arises from the benefits tax treatment of both the losses and the gains from investment property in the table below.

With these types of advantages to making your money from lazy capital gains on investment property, rather than working for a living, it is no surprise that we have become a nation of property speculators.

We can also work backwards to see in this example case how much of a loss on property the advantageous tax treatment will cover. To break even after tax all the Battler family need to do is make $4,400 after tax on the sale, which would be situation if the capital gains were $6,286, or a sale price after selling costs of $506,286. Under this situation the property investment has made a loss of $4,714 over the year (an $11,000 income loss and a $6,286 capital gain after 12 months), yet the tax system has bailed out that loss for the family through negative gearing and the capital gains tax exemption. Add another 57c or so to the project income - so it makes a $4,713.43 loss - and you are back to the same net outcome as making an extra dollar through wage income; a 40c gain.

Policy for an even playing field
We can use this example to also see the immediate impact from tax policy changes targeting investment property. If we eliminate the capital gains tax discount and quarantine losses against property incomes, we get a different story, which is in the table below.

Here the $11,000 loss rolls over to be deducted from the future income of the property, in this case the capital gains on sale, making the net capital gain of $1. Because none of this gain is subject to the CGT discount, it all adds to personal income and is taxed at the marginal rate, along with the losses in other welfare benefits. After tax both the $1 from investment property and the $1 from the wage income now provide the same benefit.

It is certainly now time for the government to end these tax concessions for investment property. Raising the GST, the current government’s preferred tax policy, is probably the worst choice in terms of both equity and efficiency compared to the low-hating fruit of removing these property tax advantages which currently cost the budget about $11billion a year. Obviously removing them would change incentives, reduce prices, and so forth, meaning that actual budget gains from their removal will be lower. But even so, the shift of incentives across the economy would be hugely advantageous in terms of both efficiency, and equity, as these tax incentives primarily benefit the wealthy.

Update:
Because many claim that negative gearing is a ‘natural result of the tax system’*, we can leave this alone and simply concentrate on the capital gains tax discount.

In this case, the table below shows how the tax benefits from negative gearing remain, yet the capital gains taxes completely offset the tax benefits from the losses made, resulting in the same net outcome. What this means essentially is that this small part of the tax code provides very perverse incentives for investors to speculate on property, than to earn income from wages.

* To the extent that any tax system is ‘natural’. My view is that you use the system to create incentives for productive activity, whether they appear natural or not.

Brisbane's Queens Wharf is a gift to casino owners

Let's bet on when the consortium entering a deal to build a new casino in Brisbane will go bust.

I will bet straight after the company has paid their well-connected senior staff handsome bonuses, and right before being bailed out (probably implicitly) by the Queensland government. As the project progresses the government will bail out the consortium either voluntarily, because the Ministers and staff involved want to build trust with the consortium, or under duress, because the consortium is going bankrupt with a half-finished major project in the CBD.  

The bailout could be in the form of cash payments. But it could also be hidden in the form of an amended scope of works. Promised investment in new public spaces around the casino will mysteriously shrink as the consortium pleas that these were never part of the deal to be delivered by them. The government will be on the hook for hundreds of millions of dollars right at a time when the budget will be drying up from the downturn of the resources and property boom.

I make this bet because I have looked that the fancy images produced to sell the project to the public, and drawing on my experience in costing large construction projects, I can assure you that adding the costs of all the public works in these images cannot be justified by the casino and hotel returns alone. It just doesn't stack up.

This quote worries me 

The Queensland Government in partnership with the Destination Brisbane Consortium will deliver… 

Public-private partnerships. Notice they didn't say those words explicitly. Because they are dirty words these days as we have come to realise that the public sector simply does not have the skills or the courage to be an equal partner. Such partnerships these days mean that all risk passes to the State while all benefits flow to the private sector partner. 

I remember sitting in a meeting with Queensland Treasury in 2009 where they were trying to get rid of these arrangements from government because they always end up tilting risk towards the government and benefits towards the private sector partners. 

But no worries. Happy to do it for a casino.

If you look at the picture below it’s almost like the government wants to get a casino as close as possible to their offices; to align themselves through proximity to the interests of the casino owners. 

I can’t think of a better way to hand money from the public to selected rich, politically-connected casino owners than this. 

For those still thinking about all the external benefits from a new casino (which is adjacent to an existing casino mind you) maybe think a little harder about the international market for high-rollers. You’ve got all of Asia to choose from. The major cities of the world. Will Brisbane now all of a sudden pop onto your radar because there is a new casino next door to the old one? A very marginal proposition at best.

Crucially, watch as the funding mechanism to capture the value uplift on the site is ignored. Gains in land value will be given away to the consortium from the inevitable government investment in public spaces and access to the area.

This will happen because the rules about paying for infrastructure are especially grey in the case of such major projects (see here, Section 6.0)

Infrastructure delivered in the PDA shall generally be funded from infrastructure charges levied on development within the PDA.
Infrastructure charges will be based on Brisbane City Council's applicable infrastructure charging document for the area or an Infrastructure Agreement.
Infrastructure delivered as part of the development may be eligible for an offset against the infrastructure charges that would otherwise apply.

The last point here is important. What it means in practice is that there is plenty of scope to negotiate that publicly accessible spaces in the casino area count towards public infrastructure, and that these might even be used to offset the standard infrastructure charge obligations under the Brisbane City Council’s plan. We have seen wiggle room like this used successfully before to get out of obligations to contribute to the public realm, with private driveways and car parks being counted as public space contributions in complete contradiction to the planning intention of these requirements. 

Essentially, the government is walking into a deal taking on a huge amount of downside risk and absolutely none of the upside. It is guaranteeing profits to wealthy casino owners in a way that is primarily a transfer to them from the rest of society. This is at a time when government revenues will begin falling, and when the city is already committing to costly projects with little to no return, such as the Kingsford Smith Drive project, where costs are likely to exceed benefits by about $200million.

But it remains possible that when the reality of the construction costs becomes apparent, the whole project might simply be canned come late 2016. 

I have no problem with government investing in public infrastructure and improvements in general, but not with the obvious intention of benefiting a select few at a cost to the rest of us. There are so many public projects out there with high benefit cost ratios waiting to be built in the city, from rail, cycle, pedestrian upgrades to improve connectivity, to the basics like stormwater and flood prevention upgrades, and so forth.

Read all about the agreement here.

UPDATE: Read all about the dodgy dealings at the blog It's Not Normal

Economic capital is like pornography - you know it when you see it

There are two parts to this blog post. First the important stuff, clarifying the weirdness of capital and the confusion of applying economic concepts in practice. Second is a rant about where the weirdness and confusion comes from, and I point the finger at the intellectual laziness of the economics profession.

Important stuff
Read the below quote. Actually, read it twice. And think about it.

Genuine foreign investment, such as the building of factories and infrastructure, adds to the nation’s productive capacity and employment, and should be encouraged. By contrast, merely transferring ownership of an existing asset to foreign interests is akin to “selling the family jewels”. It does nothing to improve the economy and living standards, and should be discouraged.

This is from a recent post by top economic commentator Leith van Onselen at MacroBusiness. On the surface it makes sense. We want investment in new buildings, machines, infrastructure and equipment. And when foreigners want to makes those investments in Australia, that’s terrific.

But we don’t want to “sell the farm” to pay for it.

The thing is, net foreign investment in productive infrastructure, of machinery, building materials, and so forth of the type that Leith explains adds to our productive capacity, always exactly matches the net sale of domestic assets to foreigners.

The bold terms are crucial, for they reveal the accounting identity at the heart of the matter.

You see, capital account surpluses indicate that a nation sold more assets to foreigners than they bought foreign assets. A capital account surplus is balanced out by a current account deficits, which means that as a nation we imported more goods and services than we exported. Having a current account deficit requires selling assets to foreigners as payment for the net imports of goods and services which contribute to our capital stock.

As I said recently, the term foreign investment is “an idiotic and misleading term for a capital account surplus. It should be called balance of trading assets for goods and services.”

Capital in the external accounts is by definition not physical stuff. It is a set of institutionalised rights. Capital in economics, however, has been hijacked to mean physical stuff, which I show below provides very little guidance for answering important economic questions.

The rant
The blame for this confusion lies squarely with the economics profession. Not only do they routinely confuse the “capital” (K) in their models with capital in the common parlance used to describe funding and asset ownership arrangements, but they also think in terms of a world where there is no distribution or trade in asset ownership; all resource use is directed by a benevolent central planner.

At best capital is like pornography - ‘you know it when you see it’. In Christopher Bliss’s introductory comments to his book Capital Theory he notes

It is a fallacy to suppose that if we have a name for something there must be something, particularly a single something, which that name defines.

The textbooks are no help at all. In one textbook I have, by Frijters, Dulleck and Torgler, all I get is “physical capital includes machines, buildings, roads, harbours airports etc.”

Ricardo arguably began this tradition of capital as stuff stating that

Capital is that part of the wealth of a country which is employed in production, and consists of food, clothing, tools, raw materials, machinery, necessary to give effect to labour.

Or perhaps it was John Stuart Mill

What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past, labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital.

Mankiw’s macroeconomics text has a similarly naive and brief definition, stating that capital “... is the set of tools that workers use: the construction worker’s crane, the accountant’s calculator, and this author’s personal computer.” And later, “the capital stock is the quantity of machines and structures available at a given time”.

The fundamental economic elements of capital seem to be:

1. They must be produced physical objects that last a non-zero period of time 
2. During that non-zero period of existence they must be an input into productive activity 

If that’s all there is to it then how can there be any non-capital goods produced? After all, food produced in one period is an input into the sustenance of productive labour in the next period. How can we walk around classifying objects as capital or consumption goods?

Look at the image below. A trained economist would call the bikes on the left consumption goods. But that same economist would turn around and call the ones on the right capital, since they are used as inputs into future production of bike hire services. Yet the ones on the left are also inputs into future cycling services as well! 

Where does that leave the core mainstream economic models? Say, the production function?

The equation below is typically used to introduce the idea of a production function, that say that output (Y) is a function of capital inputs (K) and labour inputs (L) in their strict physical economic definitions.

Y = f(K,L)

Yet if capital is everything except labour, then we can translate this equation to mean

“stuff produced is the product of labouring with other stuff”

Capital becomes merely a residual of inputs after labour (or is that just human capital?).

Once you are indoctrinated into the world of capital as physical objects, there is no where to go to explain deviations from your beliefs except in physical terms. If the model deals with physical stuff, changes in factor payments, wage levels and returns on ‘capital’ (which is quite clearly not physical stuff, since I've never seen a road or machine get paid), or even growth in output, must be the result of some mystical changes in the physical properties of stuff.

To explain these phenomena in this framework one must invoke the idea that objects have some special characteristic of being objects - a technology of objects - that allows them to transmogrify in particular ways that change their physical nature. Computers must compute more computely, and cars must drive more drively for growth to occur. And when these objects become more objecty they are then able to earn a higher ‘factor return’. Better computers bargain for better wages.

Economists are then naturally inclined to look for physical explanations of every social phenomena rather than institutional explanations. Maybe we are having a great stagnation, where objects are somehow unable to transmogrify as successfully anymore. Or maybe we are looking for physical answers to non-physical questions?

Problems with the physical object view arise in estimates of productivity (total factor or labour). The world of physical production is the fantasy world of the neoclassical production function. Some statistician is walking around pretending to measure physical quantities by looking at prices, classifying arbitrarily different objects into a stock of capital, pretending that the world rents every bit of capital from aliens, ignoring almost all the physical capital that is not in corporate accounts (like clouds, oceans, the atmosphere, mineral reserves) and stirring the Excel spreadsheet pot until a single number drops out.

When you read about the fall in Australia’s multi-factor productivity, you should laugh at the incoherence of everyone who pretends to know what it means, and feel sad of those who prescribe their own ideological remedy to the problem of a made up number going the wrong way.

You see, a negative change in multi-factor productivity is a puzzle for the production function view of the world. Does it mean we are so stupid that we combine stuff to make new stuff less effectively than we did last year? Are we getting dumber? Or is our stuff transmogrifying once again, and we are to blame the residual for our woes, and label it with the flavour of the month, like Hicks-Neutral technology shocks or something just as meaningless.

We can then say such profound nonsense as “computers made workers poor”. Okay.

Rant over.

Praise the lord! Recite the Economic scriptures

One feature of economics is its uncanny resemblance to religion. When a complex question arises outside of your narrow field of expertise, like a priest during confession, resort to the scriptures.

This is especially true for economists of a particular political persuasion, who are immune any empirical evidence that conflicts with their scriptures.

And so it is with economist polls. The University of Chicago Booth School of Business started their “experts panel”, which is the place to go if you want to see a bunch of people say that introductory economics textbooks are almost always right.

The image below shows an example. See? They all find the idea of Nash equilibrium a really powerful lens through which to view the world. I don’t. But anyway.

This craze of surveying a panel of economic experts has now reached Australia, with Monash University and the Economics Society of Australia posing tricky questions to our own high priests.

It’s so lovely that we now get our own beautiful ritual of watching the high priests periodically recite the economic scriptures.

Take the latest example. The question asks about the economic consequences of the government changing the rules around penalty rates (wage premiums) that are mandated for Sunday work (along with late night work and a range of other situations).

As you can see, 80% of the panellists agree that reducing the minimum wages for Sundays in a variety of industries will be “good” for employment and production.

From someone who agrees:

This is a bit of Economics 101 that is very likely to work

And another:

For many people, weekends are not what they used to be, and are just another part of the week. Given there would be a willing supply of labour, and a demand for it from those entities that currently close due to higher weekend costs, there should be a market outcome that suits many.

Sounds a lot like reciting the scriptures to me, without much consideration of the context. Basic questions like - Why are there weekends? Why do the wage rules exist in the first place? What non-market outcomes were desired?

But what about the minority? The 6.5% who didn’t recite the scriptures?

I think it will have almost no effect on overall employment, merely shifting activity from Saturday to Sunday. Its main effect will be to reduce the rent-sharing of workers and normalize Sunday as a regular working day, both to the detriment of workers but to the benefit of large employers. It is hence mainly a distributional issue.

And another:

The fact that there is increasing demand for services on Sunday does not imply that workers should be paid less to provide those services. In fact, one would argue that workers should be paid even more.
…
if longer opening hours on Sundays imply that consumers spend more time and money at cafes and restaurants on Sundays, then the volume of business of these shops in weekdays might decline. If this happens, than the net effect on employment becomes even more difficult to predict.

Seems reasonable to me. After all, people generally have the same annual incomes and expenditure regardless of which days of the week they do the spending. And I doubt that Sunday trading is holding back investment in new equipment that would add to the nation's productive capacity. In fact, it may hinder it.

You will notice that each of the economists on the panel has made a career out of showing why naive “econ101 assumptions” don’t apply to their field of expertise. Yet when asked about an issue outside their field, they resort to the scriptures, as if theirs is the only deviation from the textbook case. This is lazy and not at all scientific.

In general, the best way to interpret these surveys is a chance for economists to pledge their allegiance to the econ-tribe, making the whole effort a clear demonstration of economics as religion.