Should we encourage business ownership?

Politicians claim left and right that small business owners are critical to the success of an economy. They woo them with various tax credits and by turning a blind eye to their opportunities to hide income from taxation. Yet, politicians also rewards large companies with generous tax abatements, especially when the relocate or just promise not to move away. So, in the end, who should be encouraged. the small business owner or the big conglomerate? In part, this is a question about whether it is better to have many self-employed workers or many employed workers.

Mirjam van Praag and André van Stel address this question by trying to determine the optimal business ownership from a sample of 19 OECD countries over 26 years. They proceed by estimating a Cobb-Douglas production function augmented with a business ownership rate, its square, tertiary education, as well as interactions of the latter with the formers. This is not a production function that has an interpretation for factor shares, it is rather a test of some relationships in the data. And by the implied non-linearity, it allows to computed from the regression coefficients what the optimal business ownership rate would be. On average, it is 12.5%, which is definitely not high, and it declines over time.

Furthermore, van Praag and van Stel find that countries with a higher proportion of workers with tertiary education enjoy a lower optimal business ownership rate, converging towards 11% when everyone has a university education (no gravediggers?). The interpretation they offer is that better educated people run larger firms. As business owners are a minority in a developed economy anyway and only the top business owners really matter for economic performance, I am not quite convinced by this argument, but it is apparently supported by microeconomic evidence. I would have rather thought that a more educated workforce is more specialized, and under such circumstances it is more difficult to be a business owner. The only exception are start-ups, which then either fails or are gobbled up by a larger firm.

Does it make sense to subsidize biofuels?

Ina relatively short time, biofuels have become remarkably popular, especially as an additive to regular petroleum based fuel. This is at least in part due to massive subsidies from the US to fuel and corn producers. As biofuels compete with food, this has lead to major price increases for corn and sugar, with adverse consequences for importing countries. This begs the question: is it actually a good idea to subsidize biofuels? I mentioned previously that it is preferable to tax other energy products rather than subsidize alternative energies (1, 2), but let us revisit this issue.

Subhayu Bandyopadhyay, Sumon Bhaumik and Howard Wall use a general equilibrium trade model and confirm that if there is a Pigovian tax on conventional fuels, subsidies are not needed. But if the Pigovian tax is not available or too low (as is the case in the US), then a subsidy for biofuels makes sense, But if the country in question is large, there are other implications through increased worldwide demand for food. In that case, a food exporter wants to subsidize biofuels and tax conventional fuels. A food importing country would only want to subsidize biofuels if the pollution reduction effect is large enough.

Hector Nuñez, Hayri Önal, Madhu Khanna, Xiaoguang Chen and Haixiao Huang look more specifically at the interaction of policies in the US and Brazil, the two largest producers of biofuels. Indeed, the US imposes a special tariff on the importation of biofuels, in particular the more advanced sugarcane based one from Brazil. Brazil is also the largest producer and exporter of beef. The paper uses a multi-country, multi-good model, unfortunately with a partial equilibrium, but it takes into account possible crop rotations and different categories of land. It concludes that eliminating the tariffs would significantly reduce biofuel production in the US, with the latter importing biofuels from Brazil and exporting corn. While this reduces producer welfare compared to the status quo, it increases consumer welfare. Given the political system in the US, guess what will happen.

Transfers to mothers may hurt children

It is conventional wisdom in policy circles that if you want a policy intervention to benefit children, transfers have to be paid out explicitly to the mother. The understanding is that mothers care more about their children than men, and thus are more likely to use the funds for them, directly or indirectly. There is really not reason to this backfire, but as two recent papers show, it can, in fact.

Matthias Doepke and Michèle Tertilt build a series of non-cooperative bargaining models of the household and show that things can go wrong with targeted transfers or women empowerment in general. Indeed, for transfers to have an impact on the intra-household allocation of public goods, there needs to be some kind on friction. The specifics of this friction have a large impact. For example, if women are hard-wired to prefer spending on children, then transfers targeted to them may lead to over-spending on children and under-spending on other public goods that also benefit children (say, shelter), reducing child welfare. Or: if the difference between men and women is in the market wage, women will naturally tends to more time intensive activities in the household, such as child rearing. Empowering women leads them to spend less time at home, hurting the children. If empowerment implies that women have access to more private goods (such as bars or entertainment), they will focus less on public goods that also benefit children. While these examples seem a bit convoluted, they highlight that things are not so simple.

Olivier Bargain and Olivier Donni show in another series of models with altruistic parents that targeted transfers may not work as well as targeted price subsidies. They demonstrate that price subsidies have an income effect and a substitution effect, something we teach undergraduates. But they reinterpret the substitution effect as a "targeting effect." Naturally, transfers only lead to an income effect. Thus subsidies are better at improving children welfare, but they are more expensive as they apply to everyone. So it all depends on elasticities, and depending on the situation, transfers or price subsidies could be preferred.

Does hosting Olympic Games matter after all?

Is seems to be common knowledge that attracting big sports events is good for business and especially tourism. I have never found this argument particularly compelling, after all it is mostly local residents who attend such events. And previous research I reported on gives me right: in the case of the Atlanta Olympics, the impact was very short-lived and limited to the tourism industry. But maybe there is more and better evidence.

Markus Brückner and Evi Pappa take a different approach form the traditional impact study: they look at macroeconomic aggregates and focus on the anticipatory effect during the bidding process for the Olympic Games. The fact that a country is bidding gives people an indication that aggregate demand may increase in the future, especially if the country is selected into the last set of candidates. This anticipation can increase economic activity right now. Brückner and Pappa study a panel of 184 countries over 57 years. They find higher GDP growth during the five years before hosting, peaking at four years when the next host is announced. As expected, the impact fades quickly for unsuccessful bidders. And results are robust for World Exhibitions, but strangely reversed for Football World Cups. In all that, I wonder whether bidding for such large events is in fact exogenous. Indeed, you only want to bid if you have a healthy economy, especially if the event is large like the Olympic Games.

Paying farmers for landscaping

Switzerland has had for centuries a rather unique system of communal land tenure for the alpine areas. Indeed, cattle owners send their livestock up from the villages for the Summer season, and these grazing areas are commonly owned and rights to them are inherited. The returns of agriculture in the mountainous areas are, however, far from competitive in this era of globalization, and Switzerland has resorted to compensating farmers for keeping the cows up there. The reason is that cows and some other farming bring landscaping benefits, for example keeping the grass short improves snow management for avalanche prevention and skiing, or preserves biodiversity and prevents invasive plants to take foothold. These direct payments are very close to making farmers civil servants. Note that payments depend on the size of the farm, its location, the treatment of animals and the general ecological friendliness of the business.

A pair of recent papers analyze the new situation for farmers in the Swiss Alps. Chiara Calabrese and Gabriele Mack used an agent-based model to study how incomes of a large number of heterogeneous livestock farmer families would evolve until 2020. Different scenarios are explored (a not described status quo, more subsidy for summered livestock and lump sum subsidy to all alpine farmers proportional to farmed area). Results are not unexpected (no change, more summered livestock and income, less of both). Prices are assumed to grow at a steady rate unknown to reader. Give the recent wide fluctuations for food, that needs to be made more explicit and additional scenarios are needed. Also, this study basically assumes that the government does not face a budget constraint and will always be willing whatever it takes to maintain a policy. At least the costs of the program should be reported.

The other study by Nadja El Benni, Stefan Mann and Bernard Lehmann looks at how these direct payments to farmers influence the distribution of incomes. Due to the terrain, farms are small almost everywhere in the country, and Gini coefficients for farmer income have been rather low compared to other countries. The new policy increased the Gini coefficients even though the payments were implemented in part to redistribute income and they constitute now 79% of a farmers income. The reason is that the disparities in market income have increased tremendously and direct payments are tied to farm size after all.

How not to encourage home ownership

Many governments try to encourage home ownerships by various means. I am not convinced this needs encouraging, as it leads to over-acucmulation of residential capital. Additionally, it is a myth that home ownners are happier and better citizens, as I reported previously. But suppose, for a moment, that a government really wants to increase the home ownership rate. How could this be best achieved. Two recent papers look at this.

First, Emre Ergungor compares mortgage interest subsidies to mortgage down-payment subsidies, and finds the latter work better. It is clear that down-payments are a significant hurdle for first time home buyers, and the recent crisis has at least partly been attributed to too easy down-payments, so one needs to be careful with this result. This is why Ergungor looks at loan performance for low to middle incomes. He finds that a one percent interest reduction is equivalent to a $3200 down-payment subsidy in that it leads to a 75 point reduction in default rates, and the latter is much cheaper to implement.

Second, Christian Hilber and Tracy Turner make the point that the tax deduction of mortgage interest makes mortgages more affordable but also raises house values. So in the end who benefits? Apparently only higher incomes in markets with few regulations. Hilber and Turner do not try to explain why this would happen, but I suppose this has to do with the high marginal rates on tax expenditures for high incomes, although I cannot explain the regulatory impact. In any case, there is more evidence that this type of subsidy should be abandoned.

How to raise government revenue: tax bling bling, but subsidize hip hop?

Lost in the debate on how governments could be raising much needed revenue in our difficult times is that there are some goods that are just begging to be taxed: diamond goods. These goods are valued solely because they are expensive. The money spent on these goods is independent of their price. Thus taxing them all the way to infinity makes them even more attractive, as very little of the diamond good needs to be produced for the same satisfaction. Thus, everybody should agree diamond goods must be taxed heavily: the buyers because of the prestige of the high sticker price, the others for the tax revenue.

Per Engström adds a little nuance to this argument. Suppose there is a strong complement to the diamond good, like hip hop music is a strong complement to bling bling. As the diamond good constitutes a free lunch for the social planner, the latter would want to subsidize it. But that beats the purpose of taxation. However, one can subsidize the complement, which encourages the consumption of the diamond good.

Engström mentions other pairs of goods. Entry to the Sex and the City should be free and designer shoes should be taxed to the hilt. The same for James Bond movies and champagne. Any other examples?

Free university does not improve achievement equality

There are a lot of notions floating among education professionals that are actually wrong, and this has done a lot of harm as to how policies are set and how budgets are spent. The prime examples are that every classroom needs a computer, that smaller class sizes are better, or that the poor benefit more than the rich from subsidized college education. In the latter case, the underlying issue is that rich kids tend to get education for a much longer time than poor ones, and thus they benefit more from the subsidy, even after accounting for the taxes their parents pay. But would free college tuition at least enhance the accessibility of college for poor families.

Not even, claims Kevin Denny, who uses a natural experiment in Ireland, where university tuition was abolished in 1996. The explicit goal of the policy was to create more equality in access to university. Its consequence, though, to remove the small advantage lower incomes had, as they enjoyed asset-tested education grants that were abolished. In other words, the big winner was the middle class. The real equality of access problem originates much earlier than at entry into university. Lower class children have much weaker achievements in school, They need support all the way to pre-school, not university.

Olympic Games have no long-term impact on employment

Is it worth holding mega-event like Olympic Games? Repeatedly, they turn into a financial fiasco, yet new organizers keep believing they can pull it off. Usually, they manage to obtain some public guarantees or even financing on the grounds that such an event and the infrastructure will kick-start an economy and encourage tourism beyond the event.

Arne Feddersen and Wolfgang Maennig show that these beliefs are wrong, at least for the 1996 Olympic Games in Atlanta. They concentrate on the impact of these games on employment, and using monthly data they cannot find any impact in any sector, except for the sectors directly affected by the event, and only for the duration of the Games: retail trade, accommodation and food services, arts, entertainment, and recreation. How disappointing. I can only reiterate that such events should find a permanent home.

About estate subsidies and capital income taxation

There is an endless debate about estate taxation, especially in the United States. One side wants to repeal it because it discourages entrepreneurship, the other side wants to expand it, for fairness' sake. Here comes a paper that claims that both sides are wrong. Estates should be subsidized.

Carlos Garriga and Fernando Sánchez-Losada are the ones making this surprising claim. The logic is the following. Imagine that there are three potential sources of taxation: estates, capital income and labor income. You want to optimize the tax mix in order to minimize the distortions from raising taxes and maximize equity as measured by the distribution of wealth across agents. Factor also in that there is some cross-generational altruism and that one cannot bequest more than one has. One also has to realize that bequest have an important positive externality that the donor only partially takes into account: its effect on the recipient. Logically, the donor needs to be encouraged, hence the estate subsidy. But this needs to be financed somehow, hence the capital income tax. It is usually found that capital income should not be taxed, but here the pressure to raise taxes is too strong. In fact, capital income tax is significantly higher than labor income tax.

All this is done with a model that gets reasonably close to mimicking the existing distribution of skill, income and wealth in the population. Garriga and Sánchez-Losada even look into tax progression in their analysis, but qualitative results remain with constant tax rates. What I learned from this is that despite equity concerns, one has to factor in that people leave too little bequests. And that the combination of estate subsidy with capital income taxation essentially alters the intertemporal profile of wealth holding to a more egalitarian one.

The impact of wage subsidies

Several European countries, including Germany, have wage subsidies to encourage employer to hire unemployed workers. While there is no doubt that, at the margin, this can reduce unemployment, the real question is whether those hired with a subsidy also stay employed after the subsidy expires, and have longer employment spells than those hired without a subsidy.

Gesine Stephan looks at the German case and finds the subsidy works in the sense that after 3.5 years the cumulated wages are higher for the subsidized workers. But does it work well enough to justify the cost of the subsidy. On average, the subsidy amounts to €2500 to €3000. This results in cumulative wages increased by €2200 to €5000. Is this worthwhile? First, this generates more tax and social security income, second, less needs to be spent on unemployment insurance. In a carefully worded appendix, Stephan argues it looks like wages subsidies are fiscally beneficial at least to a first approximation. While this result is subject to all sorts of qualification, I am glad that, for once, a cost-benefit analysis of a policy is performed, instead of only showing that something is statistically significant.

Again: tax, do not subsidize

I reported previously that if the goal is to improve the environment, one should tax polluters rather than subsidize non-polluters. The reason is that subsidizing increases the use of resources and necessitates taxing something else to generate the income.

David Kelly provides another argument. While a subsidy may improve the environment in the short run, it hurts it in the long run. This has to do with higher interest rates, which lead to over-accumulation of capital and an increase the opportunity cost of the environment. Subtle, and this shows that partial equilibrium analysis can lead you astray.

Student aid and duration and success of study

We know pretty well that increasing student aid increases the likelihood of attending college, little is know about its impact on study duration and success. Daniela Glocker uses German data and finds that the source of support matters. Institutional student aid leads to shorter study duration than, say, support by parents. The amount of aid has no impact on duration, but improves the probability of successful completion of studies.

I find these results surprising. One would think that parents would be able to put more pressure on finishing in time than a government may be able to. Also, having more funding reduces the opportunity cost of studying, thus giving more incentives to take it leisurely, especially in Germany where students have plenty of opportunities to delay graduation. So why are those results found? One would think that this has to do with students not getting aid having to work, but it appears working time has not impact on graduation time or success. Glocker thinks this has to do with the fact that how of the loan needs to be repaid is tied to graduation time. too bad this could not be controlled for, or the results would have been really interesting.

Who benefits from agricultural subsidies?

Plenty of governments are dishing out large subsidies to their farmers. But are they really benefiting from them? If they rent the land, classic theory would indicate the land owner who be able to extract the whole subsidy from the renting farmer, simply because of the inelastic supply of land, assuming perfect competition for land.

Barrett Kirwan answers this question using US data and exploiting changes in farm subsidies. Kirwan finds that tenants actually manage to keep 75% of the subsidy. Why? Because the rental market is not perfect competition after all, something that is confirmed by the fact that tenants manage to extract more where there is less competition.

While I find it hard to justify agricultural subsidies, they are targeted towards those who farm the land, not those who own it. And it appears that this is working.

Cheaper daycare, more kids

Most industrialized countries have very low birth rates, jeopardizing the health of their retirement systems. Many governments try policies to increase fertility. However, in the name of gender equality and of improving female labor force participation, it is difficult to increase fertility while keeping females working.

The most extreme case is Sweden. Female labor force participation is at an international high, and fertility is very low, despite near universal use of subsidizing day cares. How could it be possible to increase fertility without discouraging work? Eva Mörk, Anna Sjögren and Helena Svaleryd show that increasing the day care subsidy works wonders. A lifetime equivalent of US$17,800 in subsidy led to a 4-6% increase in the birth rate. Not bad for a country that was thought to already have maximized all benefits.

Private charity vs. government support

Europeans prefer the state to help needy causes, Americans have a preference for charities to take care of this. Are government support and philanthropy substitutes or complements? If they are perfect substitutes, then it would not matter what the source is. If they are complements, you would want both to be in play.

James Andreoni and Abigail Payne point out that there is more to the story than simple crowding out. Suppose that a government provides some resources to an organization, say $100. Then people will contribute $56 less. But not all this crowding out is coming from people feeling they are not needed any more. $38 of this $56 reduction are due to lower fund raising effort. This makes it particularly important that any money the government gives should have a matching requirement from private funds to maintain the fund raising effort.

Transfers: cash or in-kind?

Should government transfers be provided in cash or in-kind? Simple economics clearly states cash is better for welfare. Just think about how cash raises the budget constraint leading to higher indifference curves. With an in-kind transfer, however, you (potentially) impose a constraint on the basket of goods, thus (potentially) reducing utility compared to he cash case. This argument is reminiscent of the deadweight loss of Christmas, discussed a year ago on this blog.

Janet Currie and Firouz Gahvani have a nice survey of reasons to provide transfers in-kind, and the circumstances where they apply. The parternalistic argument is the most obvious and applies when the government wants the recipient to consume specific goods. This would be called for when one wants to make sure children are adequately fed or are followed by health professionals. This violates consumer sovereignty, but it the whole point in this case.

But there are other reasons beyond paternalism. Social programs are often targeted, and in the presence of imperfect information for recipient identification, offering in-kind transfers leads to self-selection. for example, only needy people will show up at a soup kitchen or health clinic providing free services. Also, offering social housing in small apartments offers better selection among recipients than cash allowances. Of course, some needy people may be erroneously screened out. Note, however, that targeting does not necessarily imply overprovision of in-kind goods like paternalism does.

Cash transfers do not encourage poor people to do something about their future, as future cash payment depend on them being poor. Providing in-kind transfers takes care of this problem by forcing them into consuming goods that will help them out (education, health screening, etc.).

Finally, another circumstance where in-kind transfers make sense is when the target recipient is a member of the household that has no decision taking power. Children are such an example in most societies, and women in many as well.

Energy policy: taxing or subsidizing?

How should one encourage to use of alternative energy sources? There are essentially two market based means: subsidizing the good sources, and taxing the bad ones. So what would be optimal to do?

Essentially, the goal is to create a price wedge between good and bad, so that consumers are encouraged to choose more frequently good energy sources. So at first sight, taxing or subsidizing does not make a difference. However, subsidizing has several drawbacks. First, as the average price of energy decreases, the overall use of energy increases, which may be an unintended consequence. Second, the subsidy must be financed with some other revenue, which is typically through some distortionary taxation that generates a deadweight loss.

Thus: tax fossil fuels, do not subsidize renewable energies. Use the revenue to offset distortionary taxes.