Tuesday, April 27, 2010

Diamonds: How To Price a Finite Resource

What do you do if you are a company like De Beers, the South African diamond producer, and you own a resource that you believe to be finite? This is the actual situation faced by the mining giant, which believes that no big new diamond mines will be found in the foreseeable future. If the decision were up to you, how fast would you dig out the remaining diamonds that you own?

According to standard economic theory, the solution depends on opportunity cost. The opportunity cost of mining a diamond today is one less diamond to mine in the future, when the price may be higher. But the opportunity cost of leaving the diamond in the ground is less current revenue, which could be invested in some alternative asset like U.S. Treasury bonds. This reasoning suggests, then, that the interest rate on bonds is a good approximation for the opportunity cost of present vs. future production.

De Beers seems to think this way, too. Because it accounts for 40 percent of world diamond output, its supply decisions have a substantial impact on diamond prices, both now and in the future. It has recently announced that it will limit production to 40 million carats per year, well below the rate of production before the global economic crisis. Its aim in restraining production is to allow future diamond prices to rise at a target rate of about 5 percent per year. Could it be only coincidence that this is almost exactly the current yield on U.S. Treasury bonds?

Follow this link to download a free set of PowerPoint slides that discusses De Beers' pricing strategy in terms of supply and demand. You are welcome to use these slides in your economic course, either as part of your lectures, or as an independent reading for your students.

Friday, April 16, 2010

Who Should Celebrate, Who Should Mourn on Tax Day?

On Tax Day, April 15, protesters gathered on town squares and along city streets around the country. "BORN FREE, TAXED TO DEATH!" was the text of one popular sign. Who were these protesters? For which taxpayers does protest of the federal income tax, and other taxes, really make sense?

Not, it seems, for taxpayers in lower income brackets. According to IRS estimates, for the 2009 tax year, some 47 percent of all households will pay no federal income tax. Many of those will actually receive payments from the government under the Earned Income Tax Credit, and other tax credits.

In 2007, the most recent year for which full data are available, tax units in the lower half of the income distribution paid just 3 percent of all federal income taxes. (Tax units are not quite the same as households. One household may contain more than one tax unit, for example, spouses filing separately.) The top 1% of tax units paid 40% of all income taxes. The middle class, defined as tax units with $32,000 to $113,000 adjusted gross income, paid a surprisingly light 16% of the total.

Of course, the federal income tax is not the only tax, even if the most vigorous protests occur on the day income taxes are due. For lower income taxpayers, the payroll tax (Social Security and Medicare) is the most burdensome tax. Upper bracket taxpayers pay substantial sums in estate, capital gains, and corporate income taxes. State and local taxes are another burden that nearly everyone shares. The average rate for such taxes is 9.7 percent, varying widely from state to state.

Compared with the rest of the developed world, Americans are lightly taxed. Japan is the only high-income country with a lower average tax rate than the United States. Taxpayers in Denmark and Sweden are at the top of the list, forking over just under half of their total incomes to their governments.

So should we celebrate or mourn on tax day? We should celebrate the fact that our tax burdens are fairly low by world standards. However, that does not mean that all is well with the U.S. tax system. Our tax system is inefficient and overly complex. Whether we think the average tax burden should be lowered, raised, or left the same, the tax system calls out for reform. Proposed reforms will be the subject of future posts.

To download a free set of PowerPoint slides on the distribution of the U.S. tax burden, follow this link. If you find the slides useful in your economics courses, please post a comment and become a follower of this blog.

Tuesday, April 13, 2010

The Economics of a Soda Tax

Taxes go in and out of fashion. The hottest tax fad of 2010 is the "soda tax," usually interpreted as a tax extending to all sugary beverages, not just carbonated soft drinks.

The popularity of a soda tax is driven by claims that it attacks two of the country's biggest public policy issues: government budget deficits and health care costs. These claims are based on studies in the medical literature that show a strong link between soda consumption and obesity, and in turn, between obesity and rising health care costs. Several states, most recently Washington, have already instituted soda taxes, and the proposal is under consideration at the federal level.

The effects of a soda tax would depend, among other things, on the elasticity of demand for soft drinks. Many discussions of the policy cite an estimated demand elasticity of .79 put forward by Yale University's Rudd Center for Obesity and Food Policy. (Follow this link to the Center's policy brief on the topic.) Closer examination suggests, however, that the research underlying this number is not terribly solid. The .79 estimate comes from a meta-analysis by the Rudd Center's Tatiana Andreyeva and colleagues. The 14 previous elasticity studies they consulted included estimates ranging from 0.13 to 3.18. Revenue estimates put forward by the center assume perfectly elastic supply, so that the tax would be fully passed along to consumers.

A soda tax would produce both revenue for the government and a potential deadweight loss of foregone producer and consumer surplus. However, proponents maintain that like "sin taxes" on alcohol and tobacco, a soda tax would provide offsetting gains in the form of reduced deadweight losses from negative externalities. Potentially, a properly calibrated soda tax would both boost government revenue and raise economic efficiency.

To download a free set of PowerPoint slides on the economics of the soda tax, ready for use in your principles of economics course, follow this link. If you find the slides useful, please post a comment.

Thursday, April 8, 2010

Appreciation of the Yuan: Good for the US, Good for China, Too

From 2005 until the onset of the global economic crisis, China had allowed its currency, the yuan, or RMB, to appreciate gradually relative to the U.S. dollar. The appreciation was halted in July 2008. Since that time, China has held the exchange rate fixed at close to 6.8 yuan per U.S. dollar. Now China may soon allow the yuan to begin appreciating again. Why?

During the worst phase of the crisis, a weak yuan served Chinese interests well. Preventing appreciation helped keep the price of Chinese exports low for buyers in the United States and elsewhere. At the same time, it raised the price of imports to Chinese buyers. As a result, China's current account surplus shrank only moderately during the crisis. Together with other expansionary policies, including a huge government stimulus package and encouragement of rapid growth of bank lending, the currency policy allowed China to keep its economy expanding through 2008 and 2009. It its worst quarter, growth of Chinese GDP never fell below 6 percent.

 The effects of China's currency policy were not so welcome in the United States. A weak yuan meant that importing from China was more attractive and exporting to China was harder. That kept the U.S. current account surplus high and slowed U.S. recovery from the recession. Angry voices in Washington and elsewhere have labeled China a "currency manipulator" and demanded renewed appreciation of the yuan.

China's leaders would be very reluctant to be seen to revalue the yuan in response to foreign pressure. However, they have other reasons to consider a change in currency policy. A weak yuan has unpleasant unintended consequences for China, too. In order to prevent appreciation of the currency, the Chinese central bank must purchase billions of U.S. dollars to add to its currency reserves. Those dollars a paid for with newly issued yuan, causing China's money stock to grow at an annual rate averaging more than 30 percent.

Although the central bank has used administrative controls, sterilization, and other tools to help contain inflation, it is getting harder and harder to stem the tide. After several months of mild deflation in mid-2009, the Chinese consumer price index is beginning to rise again. Although CPI inflation is still moderate at about 2% (as of February), inflationary pressures are more strongly felt in the labor market and the housing market of coastal cities.

The bottom line: Chinese leaders now seems poised to allow the yuan to begin appreciating again, not because of U.S. pressure, but primarily to restore macroeconomic balance to their own economy.

To download a free set of PowerPoint slides with graphs and discussion related to Chinese currency policy, follow this link. If you find these slides useful in your economics classes, please post a comment or send me an e-mail.