EFB338 Contemporary Application of Economic Theory

Semester 2, 2010
Matthew Robinson
Page

THE SHADOW ECONOMY (BENNO TORGLER).....................................................................................................3

1. TAX COMPLIANCE.............................................................................................................................................................3
.1.1.Introduction..........................................................................................................................................................3
.1.2.Theory of crime and punishment..........................................................................................................................3
.1.3.Extending the theory of crime to tax evasion.......................................................................................................6
.1.4.How to measure non-compliance (methodologies)..............................................................................................9
.1.5.Evidence - what determines tax compliance?....................................................................................................14
.1.6.Conclusion..........................................................................................................................................................15
2. CORRUPTION..................................................................................................................................................................17
.2.1.Introduction........................................................................................................................................................17
.2.2.Benefits of bribes................................................................................................................................................17
.2.3.Adverse consequences of corruption..................................................................................................................17
.2.4.Causes of corruption..........................................................................................................................................17
.2.5.Measurement......................................................................................................................................................18
.2.6.Case Study – A free press is bad news for corruption........................................................................................19
.2.7.Case Study – Gender and Public Attitudes towards Corruption and Tax Evasion............................................21
.2.8.Case Study - Winning isn’t everything: Corruption in Sumo Wrestling............................................................22
3. MONEY LAUNDERING......................................................................................................................................................24
.3.1.What is money laundering?................................................................................................................................24
.3.2.Data sets & measurement...................................................................................................................................24
.3.3.How to do it?......................................................................................................................................................25
.3.4.Economic implications.......................................................................................................................................26
.3.5.Theoretical model...............................................................................................................................................27
.3.6.Future study areas / policy.................................................................................................................................27
BUSINESS CYCLES AND MONETARY POLICY (STAN HURN).........................................................................29
4. BUSINESS CYCLES...........................................................................................................................................................29
.4.1.What is a business cycle?...................................................................................................................................29
.4.2.Theory.................................................................................................................................................................29
5. MONETARY THEORY.......................................................................................................................................................32
.5.1.Introduction........................................................................................................................................................32
.5.2.Traditional case for rules...................................................................................................................................32
.5.3.Rational expectations case for rules..................................................................................................................33
.5.4.Modern case for rules.........................................................................................................................................33
6. MONETARY PRACTICE......................................................................................................................................................35
.6.1.Areas of agreement.............................................................................................................................................35
.6.2.Bodies controlling monetary policy...................................................................................................................35
.6.3.Setting the interest rate – the Taylor Rule..........................................................................................................35
.6.4.Dual mandate or price stability only?................................................................................................................36
.6.5.Explicit inflation targets?...................................................................................................................................37
.6.6.How much transparency?...................................................................................................................................37
.6.7.How to deal with asset price bubbles?...............................................................................................................37
HUMAN CAPITAL (DAVID JOHNSON)....................................................................................................................39
7. HUMAN CAPITAL ACCUMULATION....................................................................................................................................39
.7.1.Private returns to schooling...............................................................................................................................39
.7.2.External return...................................................................................................................................................39
.7.3.School quality.....................................................................................................................................................39
.7.4.Peer effects.........................................................................................................................................................40
8. IMMIGRATION.................................................................................................................................................................42
.8.1.Who decides to emigrate and where do they go?...............................................................................................42
.8.2.How do immigrants fare in the labour market?.................................................................................................42
.8.3.What affect does immigration have on native wages and employment opportunities?......................................43
9. LABOUR MARKET POLICIES...............................................................................................................................................45

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 .9.1.Types of labour market policies.........................................................................................................................45
.9.2.Types of unemployment and job search.............................................................................................................45
.9.3.Active Labour Market Policies (ALMP).............................................................................................................46
.9.4.Australia’ work for the dole...............................................................................................................................47
.9.5.Other empirical findings....................................................................................................................................48
ECONOMIC GROWTH (JAY)......................................................................................................................................49
10. INTRODUCTION.............................................................................................................................................................49
11. NEOCLASSICAL / SOLOW MODEL.....................................................................................................................................49
.11.1.Solow model.....................................................................................................................................................49
.11.2.Mankiw, Romer and Weil (MRW) & criticism.................................................................................................49
.11.3.Overview of weakness......................................................................................................................................50
.11.4.Improvements to the model...............................................................................................................................50
12. EASTERLY & LEVINE’S 5 STYLISED FACTS.......................................................................................................................52
.12.1.TFP is responsible for growth..........................................................................................................................52
.12.2.Divergence in per capital income over time....................................................................................................52
.12.3.Factor accumulation is persistent, but growth is not.......................................................................................52
.12.4.Economic activity is highly concentrated.........................................................................................................53
.12.5.National policies care closely associated with long term economic growth...................................................53
EXAM PREPARATION..................................................................................................................................................54
13. SAMPLE QUESTIONS FROM BLACKBOARD...........................................................................................................................54
.13.1.PART ONE.......................................................................................................................................................54
.13.2.PART TWO.......................................................................................................................................................54
.13.3.PART THREE...................................................................................................................................................54
.13.4.PART FOUR.....................................................................................................................................................54
MY ESSAY........................................................................................................................................................................55

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The Shadow Economy (Benno Torgler)
1. Tax compliance
.1.1. Introduction
()a Importance of taxes
Taxes are considered to be what we pay for a civilised society.
Taxes are key to the operation of a civilisation.
Although it is supposed that noone likes paying tax, without it, there would be problems in
public finance, law enforcement, organisational design, labour supply, etc.

()b Why is tax evasion is bad?

Tax evasion:

• reduces tax collections, affecting the amount of tax compliant taxpayers receiver or
the services that citizens receiver

• creates resource misallocation as people change their behaviour to evade tax

• requires government expenditure to detect and deter evasion

• may alter income distributions unpredictably

• create feelings of unfair treatment, or disrespect for the law

• reduce the accuracy of macroeconomic statistics.

.1.2. Theory of crime and punishment

()a The basic model
The economic theory of crime and punishment offers a predicted model of criminal behaviour.
The theory is based on a rational, amoral person – someone who carefully determines the
means to achieve illegal ends, without restraint by guilt or internalised morality.
In the model, crimes and punishments are ranked by seriousness and severity, such that more
serious crimes usually attract more severe penalties.
Under the theory, a person will engage in the crime when the benefits outweigh the
publishment. There is perfect disgorgement where the offence exactly offsets the offender
(represented by the 45-degree line), whereby a person will be indifferent.

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 Figure 1 - Severity of punishment as a function of the seriousness of the offence

()b Probabilistic extension

The punishment of criminals is probabilistic because the offender may escape detention,
apprehension or conviction. As a rational decision maker, the person will take this into
account.
This is done by determining the expected value of the crime, which is:
E(R) = Benefit – (punishment x probability of being punished)
Figure 2 - Probabilistic approach

In Figure 2 above, committing the offence is not worthwhile, even for an amoral person.
However, where the expected return is positive (ie where the E(Punishment) is below the 45-
degree line), the benefit of committing the crime exceeds the expected cost.
A rational person will maximise the seriousness of their offence such that they will commit the
offence with a seriousness where marginal benefit = marginal expected costs (ie until they
achieve X* in Figure 3).

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 Figure 3 - When does crime pay?

()c Aggregate crime (quantity)

We can adjust the analysis slightly to focus on the quantity of crime.
We can say that as the expected punishment decreases, the quantity of crime increases (see
Figure 4).
This is often described as the first law of deterrence. Laboratory experiments with rats have
found this to hold.
If the supply of crime is elastic, policy makers can reduce crime significantly by moderate
increases in expected punishment (Cf inelastic supply, where expected punishment will be a
relatively minor factor).
Figure 4 - Aggregate crime

()d Theories and concepts underlying crime theory

The model of rational crime simplifies reality. Crime has a number of causes, and should
usually be studied with multiple variable regression analysis.
Assumptions that underlie the economic theory are:

• the criminal is informed – he or she knoes the costs, benefits and probabilities
associated with crimes – transaction costs are not involved with obtaining this
information

• the person is risk neutral

• all the criminal’s costs and benefits are monetary.

(d.i) Diminished rationality

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 Many crimes occur where the person has diminished rationality.
Two terms are relevant:

• prudence: where the person gives reasonable weight to future events

• imprudence: unreasonably little weight is given to future events, indicating

a high discount rate.
This concept can be formalised to assume that a person’s discount rate is variable
and unpredictable, but adheres to a predictable probability distribution (ie that in
Figure 5).
As such, most of the time, a person has a moderate discount rate, ensuring that they
act prudently.
However, from time to time, a person will have a high discount rate meaning that the
benefits achieved from the offence now (ie t = 0), outweigh the future expected
punishment in the future (ie t = 1).
Under this extension, a discount rate r* is assumed to be the tipping point at which
the crime would be committed. Where the person is close to the tipping point,
small changes in punishment can be highly influential in the decision.
Conversely, where r is not close to r*, changes in expected punishment are not
effective to change the outcome.
Age reduces the variance of g(r).
Increased variability of moods (also the effect of drugs and alcohol) can increase
the probability of wrong-doing.
This implies that policy should be targeted at reducing the variability in moods (ie
reducing the episodic use of alcohol and drugs).
Figure 5 - Tipping point for lapses of judgement

.1.3. Extending the theory of crime to tax evasion

()a Traditional theory
The economic evaluation of tax compliance is based on the model of crime detailed at
1.2above.
Taxpayers will maximise the expected utility of the decision to evade tax, balancing the
benefits of evasion against the risk of detection of punishment.
The variables are:

• an individual’s fixed income: Y

• the percentage of income declared: D

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 • the tax rate on reported income: t

• the probability of getting auditied: p

• the penalty rate on each dollar that the person was supposed to pay, but did not: f.
If the taxpayer is caught, their payoff is:
Payoff = Y – t D Y – f ( t (Y - DY))
Payoff = Income – tax paid – penalty on tax not paid
If the taxpayer gets away with evasion, their payoff is:
Payoff = Y – t D Y
As such, the expected value of the taxpayer’s evasion can be represented as:
E(V) = (1 - p) (y – t DY) + p(Y – t DY – f (t (Y – DY)
E(V) = (probability of no audit x payoff without audit) + (prob of audit + caught payoff)
An individual will seek to maximise their payoff. Because the only equation that is up to the
individual is the amount to declare, we maximise for the DY. The maximised equation is:
pxf=t
In other words, the taxpayer will evade tax until the expected penalty equals the tax.
Empirical evidence suggests that people actually report more income than this model predicts.
This implies that there is a high degree of voluntary compliance.

()b Public good structure (extension)

The fact that individuals receive the benefit of government expenditure has been shown to
affect the compliance decision – the more responsible the government is in providing value,
the higher the compliance.
Thus, a person’s compliance decision will be influenced by the amount of tax they pay, the
benefit they receive and the probability of getting court:
E(V) = (Y – t YD) + m s (G + t YD) – p f (t (Y – YD))
where:

• Y is the gross income

• YD is declared income

• t is the tax rate

• m is the surplus multiplier

• s is the individual’s share of the group tax fund

• G are the taxes paid by all other group members

• p is the probability of detection

• g is the penalty rate on unpaid taxes.

Maximising the expected value equation, we find that a person will report all income if:
pf+ms≥1

()c Social norms (extension)

The basic evasion model can be extended to account for social norms, or disappropriation
associated with tax evasion:

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 E(V) = (1 - p) (y – t DY) + p(Y – t DY – f (t (Y – DY) – d (Y – DY)
where d is the disutility from evading tax, which is greater as the amount increases.
When maximised, the formula is:
pf=t-d

()d Limitations in models

The models are limited in the following ways:

• audit selection is endogenous – the integration of the audit selection rule to include
factors such as previous evasion is likely to lead to better results

• evasion is considered to be a one period game – litratutre suggests that where there
are voluntary public good contributions, contributions decline with each repition

• previous experiences or wealth changes are ignored

• it does not take into account social interactions (conditional cooperation) – ie if the
government can affect the social norm of compliance through:

• internal norms – how taxpayers judge their own compliance in light of

individual feelings about what is proper, acceptable, or moral

• external norms – how taxpayers feel to be treated by the government in

areas such as the payment of taxes, receipt of government services, or the
responsiveness of government decisions

• there are numerous extensions that complicate the analysis and make clear-cut
results hard to isolate

()e Further theories

Further extensions / approaches to compliance include:

• Bordignon (1993), who assumes that taxpayers compute whether there is a fair
trade-off between the diminished private consumption and the government provision
of public goods; if the terms differ from fair terms, the taxpayer will evade tax to even
out the unfairness, subject to the risk of getting caught.

• Erard and Feinstein (1994) incorporate shame and guilt directly into the taxpayer’s
utility; they assert that guilt is felt for underreporting even if not caught and ashamed
if caught; these are hard to work with as they are unobservable. There is the
possibility of using nueroscientific tools to explore guild and compliance.

• non-pecuniary or psychic cost increases as evasion increases, which may explain

why people refuse to take an otherwise favourable evasion gamble.

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.1.4. How to measure non-compliance (methodologies)
Because of its nature, tax compliance is concealed, meaning that economists must be creative
when attempting to measure compliance. As such, empirical evidence is relatively rare.

()a Indicative data

(a.i) Taxpayer Compliance Measurement Program (TCMP)
The Internal Revenue Service conducted intensive audits between 1982 and 1988 of
between 45,000 and 55,000 US household.
The TCMP found that:

• 40% underpaid their taxes – about 25% underpaid by more than $1500

• 53% paid correctly

• 7% overpaid

• approximately two-thrids (2/3) of taxpayers intended to pay their taxes

correctly.
Problems with the data:

• There is little information about other variables (such as socio-economic

status or demographics) that can aid in an analysis

• the information is purely based on the taxpayer’s report and the IRS
examiner’s detection of evasion, which may not discover all evasion

• it does not cover those who do not file

• honest errors are identified

• results suggest a higher audit rate leads to more compliance.

(a.ii) Tax amnesty data

Tax amnesty data is a direct measure of non-compliance, but is dependant on
taxpayers self-reporting evasion.
This method is flawed in the sense that only a fraction of those who evade tax will
participate in a tax amnesty. Those who do participate may not be representative of
the overall population.

()b Indirect methods

Tax compliance may be indirectly measured by:

• looking at discrepancies between income and expenditures in budget surveys and in

national accounts

• the difference between official labour force pariticpation rates and estimates of true
participation rates

• look for traces of unreported income in monetary aggregates (ie the use of cash in
the shadow economy.
The IRS estimates there was a tax gap of between $257 to $298 billion in 2001, indicating a
non-compliance rate between 15.5 to 16.6%.
The tax gap in switzerland is estimated to be 23.5% of all income tax for the years 1970 to

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 1995.
Problems include:

• attributing measurement errors to unreported income;

• attributing all discrepancies to undreported income

• driven by assumptions.

()c Surveys
(c.i) Introduction
Surveys are designed to elicit taxpayer’s attitudes about their reporting (tax morale).
These can be adapted to estimate non-compliance.
Surveys are amenable to collecting socio-economic and demographical information,
which helps to examine and test theories on tax evasion.
Surveys can be helpful to compare countries, or compare changes over time.
The ability to access more sophisticated statistical techniques have made surveys a
more popular mechanism to collect relevant information.
Problems with surveys include:

• that participants self-report, leading to inaccurate information – this may be

due to dishonesty or a fallible memory

• the sample may not be representative of the population

• tax compliance is a sensitive area, so those who do evade may not be

willing to complete the survey, or may moderate their views.

• framing effects – the topic / questions may create biases

• overstating the degree of compliance

• experimenter effect participants trying to please the organisers by giving the

answer they “want”.

(c.ii) Methodological techniques

Possible ways of eliciting information from participants indirectly include:

• “Does your employer deduct your personal income tax from your monthly
salary?” An answer of no may indicate tax evasion.

• “Please indicate who pays your tax on personal income or your tax on small
business.“ An answer of nobody may indicate tax evasion.

• “According to you, how many of your compatriots do the following: Cheating

on tax if they have the chance” (4= almost all, 1= almost none)?”

• using tax morale as a proxy.

Lewis (1982) suggests asking respondents whether they evade tax point-blank – it
would be worth a go.

(c.iii) Examples

(iii.A) Taxpayer Opinion Survey (USA 1987)

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 The Taxpayer Opinion Survey provides a broad set of taxpayers’ opinions on aspects
of the tax system, including the IRS, tax evasion and cheating on taxes.
Questions include “Within the past five years or so, do you think you maight have
overstated any deductions or expenses … even by a small amount?” and “Within the
past five years or so, do you think you might have left some reportable income off
your federal tax return – even just a minor amount?”, with answers being on a scale
of 1 to 4 being “definitely have not” to “definitely have” respectively.

(iii.B) Afrobarometer
Worded the question as: “We would like to remind you that your responses to this
interview are confidential. Here is a list of actions ordinary people are taking in a
political system. For each of these, please tell me whether you have engaged in this
activity or not?”
For “Avoid paying income taxes”, the variables were coded as follows: Yes, often;
Yes, a few times; Yes, once or twice: (0), No, but would do it if had the chance: (1),
No, would never do this: (2)

(iii.C) Latinobarometro
“Could you tell me if recently you have known someone or have heard someone you
know comment about somebody who has: Managed to avoid paying all his tax”
(1=yes, 0=no).
“On a scale of 1 to 10, where 1 means not at all justifiable and 10 means totally
justifiable, how justifiable do you believe it is to: Manage to avoid paying all his tax?”

(iii.D) World Values Sruvey

“Please tell me for each of the following statements whether you think it can always
be justified, never be justified, or something in between: … Cheating on tax if you
have the chance”. The question leads to a ten scale index of tax morale with the two
extreme points “never justified” and “always justified”.

(iii.E) Regression on perceived tax evasion

WEIGHTED ORDERED
PROBIT Coeff. z-Stat. Marg. Coeff. z-Stat. Marg.
Clustering
PERCEIVED TAX EVASION
-0.186*** -18.110 -0.074 -0.186*** -4.710 -0.074
CONTROL VARIABLES
(1) Demographic Factors
AGE 30-39 0.099*** 3.890 0.039 0.099*** 2.650 0.039
AGE 40-49 0.216*** 7.970 0.085 0.216*** 5.220 0.085
AGE 50-59 0.298*** 10.150 0.116 0.298*** 6.180 0.116
AGE 60-69 0.318*** 8.630 0.124 0.318*** 4.860 0.124
AGE 70+ 0.446*** 10.340 0.171 0.446*** 5.740 0.171
WOMAN 0.123*** 7.800 0.049 0.123*** 6.020 0.049
EDUCATION -0.004** -2.530 -0.001 -0.004 -1.040 -0.001
(2) Marital Status
WIDOWED -0.048 -1.590 -0.019 -0.048 -1.640 -0.019
DIVORCED -0.174*** -6.200 -0.069 -0.174*** -5.230 -0.069
SEPARATED -0.187*** -3.430 -0.075 -0.187*** -3.930 -0.075
NEVER MARRIED -0.084*** -3.740 -0.034 -0.084** -2.160 -0.034
(3)Employment Status
PART TIME EMPLOYED -0.083*** -2.940 -0.033 -0.083** -2.250 -0.033
SELFEMPLOYED -0.106*** -3.290 -0.042 -0.106** -2.340 -0.042
UNEMPLOYED 0.131*** 4.320 0.052 0.131*** 2.900 0.052
AT HOME 0.019 0.640 0.008 0.019 0.370 0.008
STUDENT -0.055 -1.510 -0.022 -0.055 -1.130 -0.022
RETIRED -0.091*** -3.070 -0.036 -0.091** -2.240 -0.036
OTHER 0.083 1.500 0.033 0.083 1.390 0.033
(4) Religiosity
CHURCH ATTENDANCE 0.041*** 13.590 0.016 0.041*** 3.630 0.016
(5) Culture/Regions
WESTERN EUROPE 0.089*** 6.000 0.035 0.089 0.860 0.035
Number of observations 32610 32610
Prob > chi2 0.000 0.000

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 NB: -ve correlation means less compliance

()d Experimental economics

The use of experimental economics has been increasing over the past 20 years generally.

(d.i) Laboratory experiments

(i.A) Why use lab experiments?

The idea of lab data is that:

• you can control naturally occurring processes, dealing with causality

• internal validity – it is replicable by any other competent investigator

• simplify – create the simpliest possible economic environment that allows

you to address issues.

• control all the variables you can

• control focus variables – by controlling all other variables, you can test the
effect of a particular variable

• randomisation – randomise experiments so that weather, time of day, etc

will not have an effect on a person’s behaviour.

(i.B) Problems with lab experiments

Problems with field experiments include:

• external validity – the result from the lab experiment may not generalise well
to the larger, ongoing outside the lab. Thus, insights may not be able to be
extrapolated to the world beyond. The choices made in the experiment may
be somewhat artificial – therefore the external validity of the experiment
may be flawed

• Human behaviour is subject to a plethora of influences

• Subjects know they are being watched, and may alter their behaviour

• Self selection – the people who participate in surveys may systematically

differ form the population; for example, volunteers may be interested in the
project or want to cooperate with the experimenter to seek social approval

• The provision of financial incentives (and its quantum) may affect behaviour

• Cannot replicate heavy penalties such as imprisonment

• There may be a lack of social pressure, meaning that there is higher

compliance than there would otherwise be

• Experimenter effect – the experimenter may influence how participants see

the experiment, so random allocation to a control group can control for this
variable – there may be level effects, such that cooperation may be higher.

• Often students are used for these experiments; problems could include a
lack of experience and the possibility for a higher IQ than the population
generally or may come from families with a higher income; age ranges may
also be limited. (NB: evidence to suggest that students’ responses are not
different from those of other subjects – indicating cognitive processes of
students are not materially different from those of other people). A reason

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 for using university students is purportedly their ability to easy understand
abstract problems.

• Replication is extremely important.

(i.C) General application to tax compliance

The application of experimental economics circumvents the problem of people not
reporting honestly and accurately as to their true behaviour.
The ability to control variables, allows researchers to identify both the relationship
between variables and causality.

(i.D) Direct measurement – Benno’s method

A typical direct experiment may have the following characteristic:

• subjects receive income each round and pay taxes on the reported income
(if the experiement has a public good, all taxes finance the good)

• tax administration is simulated by defining the probability of audit and the

tax penalty on tax evasion

• subjects are usually fully informed (but information may be used as a

treatment variable) and stay together throughout the experiment

• compare the results of treatment and control groups, by changing a variable

such as audit probability, tax penalty, tax rate, fiscal redistribution, tax
amnesties or voting on tax compliance

• the number of rounds are pre-determined but unannounced.

(i.E) Indirect measurement – Business simulation

To avoid framing effects associated with simulating tax compliance, some
experiments put participants in a business situation whereby they operate a small
business and make a number of decisions including pricing, advertising, hiring
personnel and tax compliance.
This has the advantage or experimental realism, but the downsides include that
subjects may not be used to making such decisions and that the method lacks a
certain amount of realism – ie people may not take it seriously.

(d.ii) Field experiments

(ii.A) Introduction
Field experiments allow researched to evoke real processes and behaviour, which
allows a better test of the effects of variables in the real world. This allows to
formulate practical policy responses.
An example of a field experiment would be for a tax authority to send out a letter
about the importance of tax (or provide awards for compliance) to 50% of the
population, while leaving the remaining 50% as a control, thereby testing the effect of
the action on compliance.
The benefits from field studies include:
 Allows social and economic interaction
 No observable experimental effect as participants are unaware of having
taken part in the experiment
 More representative than laboratory experiments

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  Allows researchers to test specific policy alternatives, such as the effects of
a higher perceived audity probability or the effects of moral suasion on tax
compliance
The problems with field studies include:
 Less control – may make causality harder to determine
 Need the cooperation of tax authorities
 High transaction costs to deal with tax authority
 Sensitivity of the tax filing data
 Consumes a great deal of resources
 Sometimes difficult to develop a treatment that can be hard to get approved
by the tax authority – thus unorthodox treatments cannot be used.
 Time can be a massive problem – the experiment has to be prepared before
participants receive their tax forms, and it can be over a year until all tax
forms are returned.
 Field experiments are generally only used once – it’s hard to know the long
term effects because there are not inter-temporal studies.

(ii.B) Swiss Cantons - Letter setting out importance of tax

A letter was sent out to tax payers emphasising the importance of taxes. The
experiment examined timeliness in submitting the tax return and timeliness of
payment. [Check this:] The study found that there was no statistically significant
improvement in the timeliness of payment (although the sign was as expectd),
however there was an statistically significant improvement in the timeliness of filling.

.1.5. Evidence - what determines tax compliance?

()a Penalty rates
There is a marginal improvement in compliance when penalties increase

()b Audit rates

Higher random audit rates increase compliance.
It has been found that subjects substantially overestimate the probability of an audit.

()c Tax rates

Higher tax rates lead to less compliance.
The Laffer Curve suggests there is an optimal tax rate for raising revenue, because after a
certain level, the decreased compliance due to higher tax outweighs the additional revenue
gained from compliant taxpayers.

()d Income
Higher income leads to higher reported income (but the lecture slides are unclear as to
whether this amounts to compliance).

()e Public good provision

Where there is a public good financed by voluntary tax payments, this increases compliance. [I
don’t know how that works, because it isn’t a tax if it’s not compulsorily levied by government]

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()f Tax complexity and uncertainty
Greater taxpayer uncertainty about true taxable income leads the taxpayer to report a higher
taxable income
Greater uncertainty about the tax, penalty and audit rate raises compliance.
This may be because there is a greater perceived punishment.

()g Social norms and sociodemographic variables

Elderly individuals are more compliant.
Women are more compliant than men.
Those who are self-employed are less compliant. This is often not significant, but in transition
countries, the coefficient is mostly significantly negative.
There is a positive correlation be church attendance and tax compliance.

()h Institutions
How tax revenues are used and the decision process (ie is it voted on, as in Switzerland)
affects compliance.
Poor institutions may to less compliance.
Trust in the state leads to greater compliance.
Respectful treatment by tax authorities leads to greater compliance. Treating tax authorities as
service departments leads to greater tax compliance.
Direct democracy and local autonomy are key factors – they set the rules between the state
and taxpayers. More direct democracy and stronger local autonomy lead to significantly
higher tax morale; it is posited that this is due to the fact that there is strengthened acceptance
of government decisions and hence the willingness of the public to contribute towards it, as
well as making taxpayers feel responsible for the decisions.
Fairness and transparency increase taxpayer’s propensity to contribute to public goods even if
they do not benefit from them.
If people velieve that others are honest in paying taxes, this will increase their willingness to
pay tax – this brings in the notion of reciprocity. It is posited that this represents the
diminished social disapprobation associated with evasion.

()i National pride

A sense of group identification (ie national pride) encourages cooperative behaviour – this
applies to tax compliance as well – national pride leads to greater tax compliance.

()j Tax amnesties

Tax amnesties generate a relatively small amount of additional revenue and only have small
effects on post-amnesty compliance.

.1.6. Conclusion
The plethora of factors that influence compliance makes a unified theory of tax compliance
difficult to achieve.

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Matthew Robinson 16
 2. Corruption
.2.1. Introduction
Corruption is defined as an illegal payment to a public agent with the goal of obtaining a benefit or
avoiding a cost.
Because the state controls the distribution of valuable benefits and imposition of costs, there is an
incentive for people to influence those who have discretionary power. The higher the economic
rents associated with the benefits received / costs avoided, the more incentive a person has to
evade regulations, and the higher the payments can be.
Corruption can undermine the legitimacy and effectiveness of government.
Inherent in this is the principle-agent problem.

.2.2. Benefits of bribes

Bribes can be seen as economically efficient in the following ways:
• They allow the market to clear, because the government has created a scarce benefit to
individuals and firms using criteria other than willingness to pay
• Public servants may not have any incentive to do their jobs properly, meaning there may be
significant delays – bribes in the form of ‘speed money’ may provide such an incentive
• Bribes lower the costs imposed on them by government in the form of taxes, customs duties and
regulations.

.2.3. Adverse consequences of corruption

Illegal business often purchase benefits corruptly from the state. This can go as far as dominating
arms of government, or government departments.
A willingness to accept corruption reduces economic efficiency.
Well functioning governments often create incentives to motivate employees to be honest.

.2.4. Causes of corruption

Corruption can be analysed by looking as corruption as a balancing act between expected benefits
and costs.
Level of discretionary power and economic rents. This will be influenced by the sized and scope of
the public sector.
Net utility function of corruption is a function of:

• income from corruption

• legitimate income (ie the wage of the gov officials)

• strength of political institutions

• Moral and political views of the society (including stigma)

• Probability of being caught and punished – incl independence of judiciary.

Possibility of less corruption in democratic societies due to:

• ability to vote government out of power

• higher risk of exposure in democratic systems

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• Freedom of association and of the press, allows exposure of abuses

• increased ability for citizens to get informed and involved

• Greater civic engagements = closer monitoring

• oppositions parties have an incentive to discover and publicise corruption.

Higher economic development, characterised by increased education and literacy, will often lessen
corruption.
Greater political stability will lengthen officials’ time horizons – ie they have a lower discount rate.
The greater the size of government and their control, the greater the opportunity for corruption
because there are more benefits that may be given to business.
Large endowments of valuable raw materials may offer greater potential gain for offials in the
allocation of such resources (mainly because these have large economic rents – think MRRT).
Corrupt agreements cannot be enforced – alternative mechanisms might be required – ie internal
sanctions amongst ethnic or social groups.
Asymmetric information may allow corruption to persist
Influence of religion:

• religion can foster cultural attitudes to social hierarchy

• in hierarchical religions, challenges to office holders may be rarer than egalitarian

cultures.

• Religion may influence how individuals view loyalty to family v society generally

• religion may be state-sponsored

• The church may play a role in monitoring and denouncing abuses by state officials.

.2.5. Measurement
()a General methods
• published sources – newspapers and internet

• case studies (very rare)

• Questionare (most common) – measure perceptions of corruption. Often aggregated into

Micro-level serveys or country-specific corruption perception indices. Subjective
perceptions of corruption can influence investment decisions, growth and behaviour of
people.
There appears to be a high correlation between the various proxies for corruption.

()b Perception based indices

Specific indices:

• Transparency International Corruption Perception Index – annual index that polls

businessmen or local populations for each company. Often uses a number of different
sources.

• Quality of Governance Index – mean of 6 governance dimensions from a wide number of

sources, using a large number of sources:

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 • Voice and accountability – measures the political process, civil liberties and
political rights

• political stability and absence of violence – measures perceptions of the

likelihood that the government will be destabilised or overthrown

• government effectiveness – inputs required for the government to be able to

produce and implement good policies and deliver public goods

• Regulator quality – focuses more on policies, such as incidence of

market/unfriendly policies, perceptions of the burden of regulation

• Rule of law

• Control of corruption – measures the perceived corruption.

• International Country Risk Guide – yearly data on corruption – assesses the corruption
within the political sustem.
The first two indices are highly correlated (90%).
Potential problems / biases:

• cultural background

• does the survey consist of locals or expats – more objective or ignorant of culture?

• do respondents compare to other countries?

• do respondents consider the problem of corruption relative to other problems within the
country?

• are respondents evaluating it to a high ethical standard?

()c Unique approaches

• De Soto (1989) set up a business in Lima with the aim of complying with procedures and
comply with the law. HE was asked for a bribe 10 times to speed up the process, and 2 of
those times a bribe was necessay to continue. It took 10 months to set up the business.

• Hundriks (1999) used anecdotal evidence to find that 94% of Tiwanese tax administrators
had been bribed (76% in India).

• Tracking entertainment and travel costs in China – although does include corrupt
payments, it also includes legitimate expenses

• measuring the amount of rice distributed b the amount actually received by households in
an Indonesian anti-poverty program

• Engineers’ estimated constructions costs and actual book costs (Indonesia)

• Presence of politicians on boards.

• Comparison of reported corruption and an objective measure based on Indonesian road-

building program – basically did a survey of the amount charged and the amount it would
have cost (went to local communities to find wages, got engineers to take core samples of
the road to determine the amount of material used, etc).

.2.6. Case Study – A free press is bad news for corruption

Testing whether a free press is an effective internal control on corruption.

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Proposed to work against:

• extortive corruption – government official had discretion vis-à-vis a service / permit (ie in
Phillipoines a tax inspector would assess an unrealistically high payment on the taxpayer;
it was hard to determine what the actual payment due was, and hard to appeal. Bribe of
official to give correct figure.) A free press may identify the corruption and raise the costs
for the bureaucrat – it has a platform of voicing complaints. However, an argument that
media is only concerned about large events.

• collusive corruption – discretionary power in the application of rules (ie a customs

inspector who has info about the value of a firm’s imports could agree to reduce the
overall tariff liability). This is much more difficult to detect because both parties are happy,
and have an interest to hide it. Journalists may have incentives to investigate such
corruption.
Free entry into journalism makes it hard to form a cartel covering all journalists.

()a Model
Dependent variable is corruption measured by the International Country Risk Guide
Main independent variable is a measure of press freedom (with 0 being the best and 100
worst).
Controls:

• Bureau – quality of the bureaucracy – degree of autonomy from political

pressure, strength and expertise, and recruitment and training. Higher the better.

• Rule – sound political instutions, a strong court systems – strength of

institutions and rule of law.

• GDP

• HUMCAP – educational attainment

• ETHNIC – degree of ethnolinguistic diversity as a proxy for cultural

background.

• Trade – openness to foreigh trade (should reduce monopolistic rents and

corruption

• Black – black market premium on FOREX

()b Results
The study found that greater freedom of press was correlated with less corruption (negative
coefficient). Results were statistically significant.
The study controlled for OECD / non-OECD differences and the effect was present in both cases.
Multiple indices of corruption and press freedom were used to ensure robustness – the effect still
existed.
They used press freedom at the start of a 5 year period, and the other variables over the period, to
try to establish causality.

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.2.7. Case Study – Gender and Public Attitudes towards
Corruption and Tax Evasion
()a Aim
To test whether women are more averse to engaging in corruption and tax evasion compared to
men.
An analysis necessarily involves controlling for the opportunity to evade taxes. If there were
identical opportunities, the null is that women would be just as corrupt as men.
Why are women proposed to be less corrupt:

• Cognitive, emotional and behavioural factors due to different biological,

psychological, and experiential realities

• Different involvement of women and men in the workforce and

government – women are less corrupt because they have less opportunity to be so.
It is interesting to note that:

• Motor vehicle accident rates are higher for men

• Men are more likely to be vivtims of accidental drowning or fire

• Alcohol and drug abuse are more common among men than women.

• Studies have found that women are generally more likely to contribute to
public goods or common objectives (with some caveats).

• Lower tax compliance among men.

()b Method
Used individual-level data from the World Values Survey and the European Values Survey for 8
western European countries from 1980 to 2000.
Used questions relating to the acceptability of corruption and tax evasion. Justifyability of tax
evasion is highly correlated with the Transparency International Corruption Perception Index
(0.358 – statistically significant) and Quality of Government rating (0.38 – statistically significant).
If the participation hypothesis is correct, then women should become more corrupt as they attain
greater equality.
Using countries in the same region should reduce cross-cultural comparisons.

()c Results
Women are less likely to engage in corruption and tax evasion, even after controlling for increased
opportunities to become involved in such activities. Results show very little support for the
opportunity theory.
Gender differences hold for each period and each country, despite the different opportunities for
illicit activities for men and women at different times and in different countries.
The justifiability of tax evasion indicates an increase of the marginal effect of gender from 4.2 to
7.6%.

Matthew Robinson 21
.2.8. Case Study - Winning isn’t everything: Corruption in Sumo
Wrestling
()a Introduction
In sumo wrestling competitions, there are 15 rounds, and winning 8 rounds guarantees that you
move up in the rankings, while only winning 7 guarantees you will move down in the rankings.
The average increase in rank for a win is about 3 positions, however there is a sharp non-linearity
for a win that takes you from 7 to 8 – a movement of about 11 positions.Thus, there is a much
larger incentive for a person to win if they have a 7-7 record compared to a 8-6 record.
Moving one spot in the rankings is usually worth $3000 a year.
The study examined the behaviour of participants.

()b Results
The study found that the distribution of wins in each tornament was not normally distributed – there
was a disproportionate quality of wrestlers who won exactly 8 matches (26%). This compared to
12.2% for exactly 7 wins. Under a normal distribution, these would be equal.
The authors also conducted a multivariate analysis using a probability model. The dependant
variable was winning, and the independent variables “bubble” which was 1 if the wrestler was on
the margin, -1 if the opponent was on the margin, and 0 if both or neither were on the margin.
They also controlled for ranking differentials.
They found that for the last round, wrestlers on the threshold were 25% more likely to win than
expected. The effect was present in rounds 12 – 14, but to a lesser extent, and were non-existent
in round 11.
It is arguable that the effect can be attributed to increased effort.
However, in two periods media attention focussed on match fixing; in those situations the effect
completely disappeared. This can be attributed to the deterrence model, such that an increased
probability of getting caught will make it unprofitable to cheap.
If there is collusion, corruption may be positively related to the frequency in which the wrestlers
expect to meet in the future – if they meet in the future, there is a chance for punishment for
breaking an agreement.
Top ranking wrestlers may be less likely to be willing to throw matches because there is a large
tournament prize. The study found that if the person is in contention for winning the tournament,
the bubble benefit disappears.
There were very high win rates where wrestlers were in the same ‘stable’ of wrestlers, indicating
that stables may collude between themselves to optimise utility.
The study also found that the first meeting between the 2 wrestlers after a win for the person on
the bubble, the person who was on the bubble was 7% less likely to win. This indicated that they
would allow the player to win next time (alternatively there could be monetary compensation).
Industry insiders made public the names of people who were corrupt and clean. When comparing
matches factoring in these results:

• Where there was corrupt-corrupt, or corrupt with an unknown person,

excess winning proportion was between 18 and 27%

• Where the person on the bubble was clean, against a corrupt wrestler,
there was a negative, statistically significant relationship, indicating that they lost more.

• Where it was clean vs clean, there was a positive, but not statistically
significant benefit to being on the bubble – this may indicate effort.

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Incentives are important.
It is suggested that non-linearity in payoffs allow corruption to be more prevalent.
Increased media scrutiny helps to deal with corruption as it increases the expected punishment
and probability of detection.

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3. Money Laundering
.3.1. What is money laundering?
‘Money Laundering’ is derived from the Mafia’s attempt to ‘launder’ illegal money via cash intensive
washing salons in the 1930s.
It is defined as the process of transferring money between the official and the unofficial economy.
The IMG estimates that 2-5% of the world’s GDP stems from illicit sources and therefore must be
laundered.
Money laundering is estimated to be worth approximately AUD2.8 billion. This is largely attributed
to fraud / tax evasion, and then illicit drugs. This is typically invested in:

• Further criminal activities – 21%

• Professional services 7%

• Real estate – 23%

• Gambling - 16%

• Luxury goods – 15%

• Legitimate business – 12%

.3.2. Data sets & measurement

Difficult due to illegality and hidden nature.
Measurement approaches:

• Currency demand approach – money laundering is usually done with

cash payments, so its effect should be included in currency demand – the goal is to
isolate it from legitimate currency demand

• Measuring electricity consumption may be a way to calculate the size of

the shadow economy, because it captures both illegal and legal economic activity

• Amount of money confiscated / convictions

• Direct subjective measurements – often uses surveys of experts – this

can have disadvantages such as reliability of experts, small sample sizes, only measures
perceptions (although there is a correlation between perceptions and observable
behaviour). Note however the indices are highly correlated amongst themselves.
Measures include:

• Pevasiveness of money laundering through banks

• Pervasiveness of money laundering through non-bank channels

• Perception of no. of percentage of businesses that are unofficial /

unregistered.

• Perceptions of how much organised crime impacts on the cost of doing

business.

• Perception of tax evasion in the country.

• Global Competitiveness Report

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 • Executive opinion survey that avoids the limitations of official statistics

• Expert opinions of business leaders and entrepreneurs – should

represent the main sectors of the economy - CEOs and their staff members.

• International Country Risk Guide

• law and order assessed separately – law sub-component assesses

strength and impartiality of legal system – order sub-component is the popular
observance of

• Corruption – corruption within the legal system – actual or potential

corruption in the form of excessive patronage, nepotism, job reservations, favour-
for-favours, secret party funding & close ties between business and government.

• Bureaucracy quality – strength and expertise to govern without drastic

changes in policy or interruptions in government services.

• Banks’ Cross-National Time-Series Data Archive – Conflict Index –

covers assassinations, general strikes, guerrilla warfare, government crises, purges, riots
and revolutions.

• World development indicators – GDP per capita growth – affects the

opportunities of money laundering and investment (r increases and c decreases).

• Money laundering regulations index

• Financial system regulation and disclosure – degree to which the

authorities requires customers identification and record keeping, financial
institutions rules, etc

• Criminalisation – degree in which money laundering is considered a

criminal offence; confiscation – degree in which the auythorieis take provisional
measures and confiscations relating to money laundering.

• Administrative authorities – depending on implementation and rrole of

the regulatory and other administrative authorities regarding money laundering

• International cooperation – international information exchange and

international confiscation.

.3.3. How to do it?

Money laundering is a 3 stage process:
1. Placement – moving the funds from direct association with crime

• Smurfing and structuring – breaking up a large deposit into smaller

deposits to avoid currency transactions

• Camoflage – getting higher amounts into the banking circuit by using

flake passports and fake IDs

• Currency smuggling – smuggling large amounts of cash over borders

• Travelling cheques – purchasing travellers’ cheques with dirty money

• Gambling - Converting cash into chips at the casino, and obtaining a

cheque from the casino showing a legitimate transaction.
2. Layering – disguising the trail to foil pursuit

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 • Correspondent banking: sender – bank of sender – SWIFT – Bank of
receiver – Receiver

• Bank cheques – transfer funds between persons or jurisdictions

• Collective accounts – working with a person of reputable standing

• Payable-through accounts – Accounts with the ability to conduct

business in a second country as if the person had an account in that country

• Loan at low or no interest rate – allows to transfer large amounts of cash

to other people, which will be paid back slowly.

• Money exchange officers – corrupt exchange office / own the exchange

burea. Paying taxes on profits gives it an air of legitimacy.

• Money transfer offices – international money transfer agents are

controlled to a different extent in different countries

• Insurance market – arrange insurance policies on assets, and claims on

the policies can be returned to the launderer.

• Fictitious slaes and purchases – using legitimate organisations, explain

exra income showing in the accounts

• Fake invoicing – but note transfer pricing regulation.

3. Integration – making the money available to the criminal, with its origins hidden.

• Capital market investments

• Financial assets that can be purchased by the launder in order to invest

the cash in reputable enterprise

• Real estate acquisition – later sold as a legitimate source of cash

• Catering industry – highly cash-intensive business

• Gold & diamond market – can be purchased easily, with a high intrinsic
value, and relatively compact.

• Purchase of consumer goods to be shipped overseas, and then sold

• Acquisition of luxury goods

• Cash-intensive businesses – exchange businesses, restaurants, etc

.3.4. Economic implications

Can damage the financial system – its credibility and stability. It can corrupt confidence in the
system.
It can distort investment patterns, as launderers do not seek the most effective investment.
The costs of money laundering reflect on the cost of illegal activity, so will have an impact on the
size of the underground economy.
Money laundering has the potential to reduce the rate of growth.

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.3.5. Theoretical model
()a For launderer
Based on conventional criminal theoretical approaches, the expected utility of the activity can be
written as:
E=U[(1-p)(R-C) + p(-C-F)]
= probability of getting away * (expected return [ R=(1+r)Y ] – cost of money laundering [C=cY] +
probability of getting caught * (cost of money laundering and punishment)
There will be an optimal point, which is:
Y* = [m (1 - p) - c] / [2 p f]
This will mean that an increase in the punishment, fine rate or cost will reduce money laundering.

()b For government

It may be optimal for a country to allow a certain amount of money laundering because of flow-
throughs to other sectors.
Countries that allow it are referred to as Lax Financial Regulation (“LFR”) countries. We analyse
them from a ‘small country’ perspective.
The policy maker can allow money to be laundered (Y) between 0 and the demand for money
laundering (W). The laundering does not directly provide utility to the policymaker, but may
receiver and external benefit (B = mY). Where m > 0, there is a benefit to the policymaker, which
may be due to the additional flow of black foreign capital, producing national revenues, increasing
activity and associated follow throughs due to the multiplier effect.
These benefits are subject to costs, such as reductions in the country’s credibility and reputation
(c), strengthening internal organised crime or terrorism (γ). Assuming criminal costs are more
significant for the policy maker, the overall cost can be expressed as:
C = cY + γ2 Y
Foreign countries may impose a sanction (S) with a probability of (p). Assuming that the sanction
is greater than Y, expressed as a multiple, and that different severity will be imposed, we can
express the sanction as:
S = t Y2
The policymaker’s expected utility is therefore:
E(U) = u [(1 – p) (B – C) – p (C + S)]
Optimised, we find that:
Y* = [m (1- p) – c - γ2] / [2 t p]

.3.6. Future study areas / policy

• Effect on globalisation

• Increase in money laundering along with terrorism

• Money laundering merely a symptom of illegal activity – so addressing the illegal activity
may be more effective.

• Loss in efficiency due to regulation of banks

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Matthew Robinson 28
Business cycles and monetary policy (Stan Hurn)
4. Business cycles
.4.1. What is a business cycle?
3 key elements:

• A business cycle occurs in economic activity

• The cycle has phases of expansions and contractions

• Cycles occur in many activities

The parts of the cycle are described:

• Peak – top of the cycle

• Recession – downward trend

• Trough – bottom of the cycle

• Recovery – upward trend

Economists distinguish between the classical cycle which is the level of the GDP series, whereby a
recession is classified where there is negative growth, and the growth cycle where GDP is de-
trended, whereby a recession is classified as below-trend growth.
During periods of sustained growth, there always appears to be murmurs that the business cycle is
dead.

.4.2. Theory
()a Keynesian
Keynes emphasises an autonomous reduction in investment generated by a lack of confidence,
but did not set out how this would work.
A mechanism is one which consumption is smoothed and if investment is entirely driven by animal
spirits, then national accounts identity shows that output would be a highly persistent process with
animal spirits as the driving force.

()b Multiplier-Accelerator Model

Consumption responds directly to current output, but investment is driven mainly by lagged output.
Ct = α + βYt
It = v (Yt-1 – Yt-2)
Yt = (v/(1-β)) (Yt-1 – Yt-2) + (α / (1+ β))
This is a 2nd order difference equation in Yt. The solution depends upon the precise values of the
parameters, but cycles in Yt can easily result given an autonomous change in α.

()c Monetarist Theory – Friedman - classical

Monetarists emphasised the role of the money stock in providing the impetus for the cycle, rather
than shifts in investment. This is based on the following:

• Money is neutral – classical dichotomy

Matthew Robinson 29
• An unexpected growth of the money supply and the certeris paribus higher nominal prices
and wages that go with it, make producers and wage earners overestimate the real prices
and wages for their products and services. These overestimated prices and wages induce
an increase in both production and the necessary labour supply, thereby creating an
economic boom.

• In the reverse situation, when money growth unexpectedly declines, the process too is
reverse: real prices and wages are underestimated because of the certis paribus lower
prices, and production and labour supply will be down. In this case there is a slump in
economic activity.

• Natural rate of employment / output  assume A & K are fixed in the cobb-douglas
equation  labour market equilibrium determines the output equilibrium.

• The effects on production and labour supply will be especially large if the perceived
changes in real prices and wages are regarded as temporary, as this will give rise to an
inter-temporal substitution of labour supply: in order to maximise leisure and income,
producers and labourers will work more when prices and wages are perceived to be
temporarily high and work less when they are perceived to be temporarily low. This
emphasises the importance of expectations in the formation in the building of models of
the macro-economy.
Problems with the basic Friedman-Lucas model:

• There will only be prolonged periods of above and below average growth under the
(unrealistic) assumption that people systematically err in overestimating prices in the
boom and underestimating them in the bust. Taking inflation into account, there will be no
periods of booms and recessions but only random deviations from trend growth.

• Since changes in the inflation rate are usually quite moderate, it is not realistic to consider
them to be the cause of major short term fluctuations in labour supply. Further, the ability
to adjust working hours may be difficult.

()d Real business cycle theory

RBC has its routes in microfoundations rather than macro analysis.
According to RBC theory, business cycles are real in that they do not represent a failure of markets
to clear but rather reflect the most efficient possible operation of the economy given the structure
of the economy.
RBC theory differs in these way from other theories of the business cycles in that it does not see
recessions as a failure of the market to clear.
RBC theory sees recessions and periods of economic growth as the efficient response to
exogenous changes in the real economic environment. This may be in the form of technological
shocks (ie random fluctuations in technology).
Effectively, the rationale is that the behaviour is not ‘optimal’ in the sense that it is the best
outcome regardless of the economic environment, but people make optimal decisions given the
situation they face.
In a recession, consumption falls an leisure rises; in a boom, consumption rises and leisure falls.
Consumption-investment decision: People will smooth their income over their life (Permanent
Income Hypothesis). As such, they will save in periods of high income (booms) and defer
consumption to periods of low income.
Labour-leisure decision: It is assumed that when productivity is high people will substitute
leisure for labour. There is also an income effect, whereby earning more will cause people to not
need to work as much. However, the microeconomic literature indicates that the substitution effect
dominates the income effect.

Matthew Robinson 30
The basic RBC model predicts that a positive temporary technology shock will result in rises above
their long-term trend in output, consumption, investment and labour. The rise can be persistent
because the additional investment means higher capital for future periods (this is referred to as
internal propagation).
Criticisms with RBC include:

• Do changes in unemployment reflect voluntary changes in labour?

• Does the economy experience large, exogenous productivity shocks in the short run? This
can be tested by plotting changes in output with the solow residual, which should
represent TFP.

• Is money really neutral in the short run?

• Are wages and prices fully flexible in the short run? ie are prices sticky – this is the basis
of New Keynesian theory.

()e New Keynesian Business Cycle

New Keynesians concede that in the long-run there is a natural level of output / labour, but argue
that money is not neutral in the short-run.
They believe that deviations from equilibrium in the short-run are due to wage and price stickiness.
This is posited to be due to:

• Menu costs – changing prices is expensive, so firms will not change them if the cost of
changing them is greater than the increased revenue. Sticky prices may be optimal for the
firm even though they are undesirable for the company. This assumes monopsonistic
competition, as the firm must have some control over its prices.

• Coordination failure: In recessions, output is low, workers are unemployed and factories
sit idle. Markets could clear if people were willing to cut their price or wages, but are
unwilling to without knowing that others will do the same.

• Staggered wages and prices: all wages and prices are not able to adjust simultaneously.
Pricing decisions cause the price/wage level to adjust slowly. Further, as individuals and
firms know wages / prices are slow for a while, so are unwilling to accept this.

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5. Monetary Theory
.5.1. Introduction
Models that allow output to be suboptimal (ie those that do not require the market to clear) allow
for economic policy to be used to improve welfare through the persistence of shocks and the
amplitude of the cycle.
Policy is always subject to lags, such as:

• inside lag – when it is recognised that policy should be applied to when it actually is

• outside lag – time for the policy to have its effect.

Fiscal policy has a long inside lag, but short outside lag. Evidenced by yearly budgets.
Monetary policy is assumed to have a short inside lag, but a long outside lag. Monthly RBA
meetings.
Because of the short inside lag, we assume that only monetary policy is used to stabilize output.
This is also because fiscal policy has equitable & political considerations.

.5.2. Traditional case for rules

A rule is a set of procedures which specifies what policy should be under any given set of
circumstances.
A discretionary fiscal policy allows policymakers to re-optimise continuously.
The traditional rationale for a monetary rule is that it creates certainty.

()a Simple example

Suppose y is determined as follows:
yt = a0 yt-1 + b0 mt + b1 mt-1 + ε t

where the ay term is the persistence in output, the b & m terms are the effect of previousl and
current monetary policy and ε t is a shock that is autoregressive distributing model, that is
independently identically distributed (ie ah a mean of 0). Under such a model, we assume mt is set
prior to observing ε t, so the goal is to minimise the variance of yt. The optimal variance
minimising policy is:
b a
mt =− 1 mt−1 − 0 yt−1
b0 b0
If this is substituted back into the yt equation, yt equals the shock term, ε t. Such a policy removes
all persistence in output. This may be seen as the outcome under discretionary policy, sincnce it is
what would be chosen if there was re-optimisation each period.

()b Problem
However, if b1 > b0, we have an unstable difference equation, where mt will be increasing in
absolute value at an explosive rate. To deal with this, a ‘correction’ is applied to the previous
period’s policy such that:
yt = a0 yt-1 + b0 mt + (b1 + v) mt-1 + ε t

where v is some constant. Under this situation, output is:

yt = v mt-1 + ε t

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Under this assumption of non-stationarity, which is in fact explosive, the growth rates of mt and
mt -mt-1, the variance of y is growing over time, such that the amplitude of the cycle is increasing
merely due to slightly mis-estimating b1.

()c Comparison with rule

If mt =m-bar, the variance of output will be almost as small as for a discretionary policy, for
sufficiently small values of a0, despite the central bank not knowing the structure of the output
equation. Thus, having money constant may provide a much more stable policy than a
discretionary policy where parameters are uncertain.

()d Friedman’s arguments for rules

Friedman argues that less variable policy is superior in the presence of uncertainty. This is
because if you don’t know the structure of the economy, then policy can destabilise. This also
fitted with Friedman’s belief that there was no point in using monetary policy to affect output
because in the long run the natural rate of unemployment prevailed.

.5.3. Rational expectations case for rules

Rational expectations is premised on the assumption that the level of prices will equal the
expected level of prices given the information available, plus a error term that is iid.
Criticisms of rational expectations are focused on:

• Even if the structure of the model is correctly perceived, computational difficulties will
defeat the majority of individuals. Further, it is assumed that rational individuals do not
make systematic errors, however in reality this may not be accurate. Also, it assumes the
people have sufficient information.

• the impossibility of discovering the correct model – there may be substantial disagreement
about the structure of the underlying model. The Lucas critique states that the behaviour
of rational individuals depends on the model adopted, and therefore changes in policy will
have unknown consequences because it will change people’s behaviour – ie encode
policy in behaviour.

• challenging the incentive to acquire information. If the price incorporates all possible
information about the thing, and therefore price = value, then there is no need to gather
information. Rational individuals will merely get an average of published inflation
predictions. The concern that there will be no incentive to gather information.
Under rational expectations theory, the output solution does not contain any monetary policy
parameters, indicating that monetary policy is irrelevant.
This conforms with the Sargent & Wallace (1976) proposition that output only deviates randomly
from its natural level. This is called the policy invariance proposition. Under this model (and
rational expectations):

• expected monetary policy cannot affect the level of economic activity in the model, since
output does not depend on any of the parameters of the monetary policy rule.

• Unexpected monetary policy does affect economic activity in a random way (because it is
random, a rule would reduce the variance of the residual).

• The use of ‘monetary surprises’  this leads on to the modern arguments for a rule.

.5.4. Modern case for rules

The modern case for rules is based on the notion that policy makers will have an incentive to fool
people to obtain short-term advantages (namely increases in output) that result in lower welfare

Matthew Robinson 33
than would otherwise be the case (ie if policy-maker’s hands were tied).
The government has an incentive to create unexpected inflation to put output above the natural
rate. This creates a societal loss, because inflation is above the social optimal level. This is
attributed to Barro and Gordon.
Rational agents will expect this, and therefore the economy will have an inflation bias. This is
eliminated by the use of a rule because the government does not have the ability to affect policy.
Thus, provided that the rule is credible, a rule will be superior.
It is suggested by having an independent central bank, which is more adverse to inflation than the
rest of society, inflation will be lower when an independent central bank is delegated monetary
policy.
New Zealand attempts to induce policy makers to be more inflation adverse than society by
making their salaries tied to low inflation (often described as Walsh Contracts).
However, having a central bank be completely adverse to inflation would be detrimental if there are
disturbances to aggregates supply, which would result in an increase in the variance of output.
Central banks have an incentive to pay a game where they minimise inflation for multiple periods,
but then cash in their reputation to follow society’s preferences. They then re-build their credibility.

Matthew Robinson 34
6. Monetary practice
.6.1. Areas of agreement
Economists generally agree that:

• there is a unique medium run equilibrium rate of unemployment or output which is

consistent with constant inflation. The long run will be determined by institutional and
supply side factors. There is not necessarily a relationship between unemployment and
inflation in the short run.

• The speed of movement to equilibrium output/unemployment will depend on the decisions

of policymakers, such that money is not neutral in the short run. Expected and
unexpected policy can effect the short-run.

• Monetary policy should be transparent (one way of doing this is to delegate the power to
an independent policy maker).

• An appropriate policy instrument is nominal interest rates. The way the economy adjusts
to a new equilibrium with constant inflation is encapsulated in an interest rate rule.

.6.2. Bodies controlling monetary policy

There is always a tension between what can be done in the short run and what should be done in
the long run – this is the essential policy challenge.
{left out bits on different central banks}
Most central banks have a committee structure, which is favoured because:

• A committee pools the disparate knowledge of its individual members such that it obtains
a wide view

• Members of a committee bring different decision making heuristics to a complex problem

• Committees are less likely to adopt extreme or idiosyncratic positions – they will tend to
inhabit the middle ground.

• The decisions of a group are likely to be less volatile.

Price stability seems to be the primary objective, but there is often a dual mandate. Price stability
often includes:

• public announcement of medium-term target

• institutional commitment to price stability

• information inclusive strategy – such that the central bank shouldn’t disregard information
so they have the flexibility to react to new information

• increased transparency through public communication

• increased accountability.

.6.3. Setting the interest rate – the Taylor Rule

The Taylor rule is a 2 gap model (meaning it depends on the inflation and output gaps) that results
in a simple linear reaction function.
The Taylor Rule states that the nominal interest rate should be:

Matthew Robinson 35
 t=
i α
+β
ππ
( π
t−)+
* β
(
yyt−
y*
)
If output and inflation are at target levels, then the interest rate will be a. The real interest rate is a
minus the target level of inflation.
Taylor suggested that β π = 1.5 and
βy =0.5. These coefficients are much more contravertial
than the basic theory behind the taylor rule. However, there is agreement that β π> 1. This is
because you need to have sufficiently high interest rates that you are not seeing a decrease in the
real interest rate.

()a Inflation
There is debate over the index that should be used. Some argue that the headline figure of CPI
should be used as that reflects the price that needs to be paid by consumers, while others argue
that underlying CPI should be used because that strips out changes in prices of volatile items (the
argument is that there is no point using monetary policy to combat temporary price rises).

()b Target
A target of 2% is popular, but there is little to suggest that an inflation rate of 3% is much more
detrimental.

()c Output gap

Measuring the output gap is difficult. It can only be measured historically, so economists often use
trend data to extrapolate. This leads to difficulties if there are changes in potential output.
Further, even obtaining actual GDP figures is problematic given that they are only released
quarterly.

()d Equilibrium real interest rate

The equilibrium real interest rate may not be constant over time – as such when economies are
growing quickly, the real interest rate is likely to be higher. Compare this to Japan, where the real
interest rates are low to make borrowing for capital expenditures worthwhile.

()e Does behaviour mimic the Taylor Rule?

The Taylor rule was a reasonable estimator of monetary policy over the Volcker-Greenspan era
(with an r-squared value of 0.75).
There were persistent deviations from the rule, which often constituted concern for the economy
which was not represented in inflation and output data. For example, in late 1998 the fed cut rates
despite a strong economy due to the Russian debt default and Asian Financial Crisis. Similarly, in
2002-03, the fed lowered rates below what the Taylor rule would predict (even for a sluggish
economy and low inflation).
Central banks will want to smooth interest rates, so a lag term in the taylor rule may create more
accurate results.

.6.4. Dual mandate or price stability only?

Some central banks (ECB and Bank of Enlgand) have a strict inflation targeting mandate, while
others (the Fed and the RBA) have dual mandates that require them to consider inflation and
growth.
Arguments against dual mandates:

• they can undermine central bank credibility – if there is not confidence that the central
bank is not completely focusing on low inflation, then inflation expectations are not likely to
be anchored.

Matthew Robinson 36
• Monetary policy has limited influence on unemployment in the long run, so why make the
central bank responsible for this?
Arguments in favour of dual mandates:

• Central bankers do care about GDP and unemployment, so why hide it?

• Stabilising output will avoid big recessions and booms.

• There may not be any internal inconsistency with inflation targeting and a dual mandate.
Low inflation helps to boost economic growth over the long run by saving time and energy
associated with dealing with high inflation: having to reset prices regularly, re-write
contracts to deal with inflation, etc; facilitating long-run decision making, with consumers
and businesses not having to worry about uncertainty about the future price level;
enhancing the price signals and thus the functioning of the market.

.6.5. Explicit inflation targets?

Arguments in favour of a specific inflation target:

• readily undertood and increases transparency

• it shows the central bank is serious in its commitment to low inflation

• it provides an explicit metric that the public can use to assess the central bank’s
performance

• and explixit target may help to anchor inflation targets.

Arguments against an explicit inflation target:

• Which price index to use? The choice in indices can have large effects on the result.
Maybe it would be advisable to look at the trends in a number of indices.

• There is little indication that 3% inflation is significantly more harmful than 2% - the priority
should be to ensure stable growth within moderate levels of inflation.

• Reduced flexibility in the face of financial instability.

It is interesting to consider whether policymakers have an asymmetric response – ie are they more
concerned with high inflation than low inflation.

.6.6. How much transparency?

Argument for transparency: If the bank has a serious commitment to low inflation, then letting the
public see exactly how the process works may improve credibility.
Argument against transparency: Sometime economists disagree and these disagreements may
not be well understood by the public.
Central vanks usually issue caregully-worded statements to provide guidance to financial markets.
Lars Svennson argues that central banks should flag their intended future path. This would be far
more precise than the lingo used currently, and may allow greater control over long-term rates.
However, it could be argued that the public may see projections as commitments, and get
confused, or see the central bank as indecisive.

.6.7. How to deal with asset price bubbles?

Asset bubbles are usually characterised by innovation that results in a surge in economic activity,
but the innovation makes markets uncertain as to the extent of benefits arising from the innovation.
This makes it hard to determine the existence, size or persistence of an asset bubble.

Matthew Robinson 37
Policy maker may lean against an asset bubble by raising rates, effectively taking out insurance
against the risk of an asset bubble.
However, it is often argued that the cost of departing from optimal monetary policy is much more
costly than the benefits achieved from leaning against the bubble. This is especially so given that
bubbles have not proven to be particularly sensitive to the level of short-term interest rates.
Tools that are often used are:

• the bully pulpit: public question the assumptions underlying the bubble and threaten
policy to prevent the bubble.

• Macroprudential tools: Regulatory & supervisory actions applied on a general basis – ie

facilitating markets that allow people to short sell.

• Monetary policy – tighten monetary policy to lean against the wind / bubble.

Matthew Robinson 38
Human capital (David Johnson)
7. Human Capital Accumulation
{Most of the content about private and public returns to schooling are included in the essay at the
end of the notes}

.7.1. Private returns to schooling

The return to schooling is often measured as a regression, represented by:
ln(W) = a + b S + other variables
To control for ability bias, studies have used:

• identical twins

• individuals born at the beginning and end of year

• differences between people subject to different numbers of years of compulsory

schooling.

.7.2. External return

There is a significant externality associated with additional schooling.

.7.3. School quality

Differences in school quality (teacher-pupil ratios, spending per-pupil, length of school year,
educational qualifications of teachers) may be a major determinant of human capital.

()a Teacher quality

Researchers agree that teacher quality does matter, however it is hard to define what a good
teacher is.
Teacher incentive schemes are gaining popularity in Australia and elsewhere, but are met by
strong opposition by teacher unions.

()b Class sizes

Reducing class sizes is a popular policy from a government’s perspective because:

• class sizes can be reduced without disturbing the overall structure of the school system

• it is easy to implement and visible

• teachers are usually supportive (may have their own interests in mind).
Smaller class sizes are said to improve achievement because it allow more time to be devoted to
each student. Lazear (2001) provides a formal model which states that a person learns more in a
smaller class because each student is disruptive for a certain percentage of the time, which means
that the greater the number of students, the greater proportion of time they are going to be
disruptive.
It is hard to measure the effect of class size, because assignment is usually not random:

• If high achieving students are put into small, advanced classes, estimates will be upward
biased

• if low achieving students are allocated to small, remedial classes, estimates will be

Matthew Robinson 39
 upward biased.

• allocation may be due to family attributes, such that wealthier families may move to
districts with smaller class sizes.
Empirical evidence:

• Hanushek (2003) argues that increases in school resources are an ineffective way to
improve school quality – finds improvement is not consistent.

• Krueger (2003) claims that Hanusek’s methodology is invalid.

• Most studies fail to find a large, positive class size effect.

• It is possible that sizes are close to optimal, such that further reductions have little
marginal effect, or are so small they are difficult to detect in small samples.
The positive effects (if any) of class sizes are thought to be outweighed by the large cost.

()c The STAR project

The Student/Teacher Achievement Ratio (STAR) experiment started in 1985/86 an represents one
of the biggest education experiments ever attempted. 11,600 students in 80 schools were involved
in the experiment.
Kindergarten students and teachers were randomly assigned to small (13-17), regular (22-25) and
regular + aide classes (22-25 plus a full time teachers’ aide). After 3rd grade, the experiment
ended and all students were assigned back to regular classes. Students were to remain in their
allocated class for the 4 years.
Problems:

• students were not randomly assigned to schools, so there may still be school effects

• 10% of students switched between classes, primarily because of behaviour or parental

complaints.

• Only done over a few grades.

Students in the smaller class size performed better. However the effect was small.
The benefit did not increase over time.

.7.4. Peer effects

()a Introduction
Being in a class of bright students may impact your education because the student gets:

• more insights in class discussion.

• Experiences less negative disruptions

• Feels more pressure to compete

• Better understands the importance of education (higher aspirations).

There are three sources of peer effects:
1 Endogenous interactions: the propensity of a student to behave in some way varies with
the outcomes of the group – individual achievement varies with the average achievement
of the students in the individual’s peer group.

Matthew Robinson 40
 2 Contextual interactions: propensity of a student to behave in some way varies with
background characteristics of the group members 0 eg individual achievement varies with
the socio-economic composition of the group.
3 Correlated effects: students in the same group tend to behave similarly because they
have similar individual characteristics or face similar institutional environments – eg
individuals in the same school tend to achieve dimilarly because they are taught by the
same teachers.
Distinguishing between these are important. For example, if there are endogenous interactions,
increasing the academic performace will have positive effects on other students through feedback
effects. However, no feedback effects will occur if there are only contextual interactions or
correlated effects.

()b Optimal composition

The optimal composition of students will depend on whether students are complementary, or
whether their learning can be classified as a negative cross-partial derivatives.
If students are complementary, the highest quality individuals should be matched. This effectively
means that students should be segregated along income lines, as high SES students are deemed
to be ‘higher quality’.
Under a simple model, a student’s human capital will depend on parental background (ie their
expenditure on inputs) and that of the other student(s). The cross-partial derivatives imply that the
backgrounds of two students are complementary, such that a good student is particularly benefited
by having another kid from a good background. This would mean that it is socially efficient to
segregate students according to parental background.
However, if there are negative cross-partial derivatives, students with a good background bring the
rest of the class up, but help students with poor backgrounds more than they help students with
good backgrounds. Thus, poor-background parents would want to have their kids in school with
good-background students. Under this scenario, it is optimal to have schools with a mix of
children.
Just because we observe segregation, does not necessarily mean background is complementary.
Theoretically, students from bad backgrounds should pay students from good backgrounds to go
to their school, as they receive the highest benefit, but this is impractical.

()c Empirical problems

Individuals self-select into peer ground, which makes it difficult to separate selection effects from
peer group effects.
If two people influence each other simultaneously, it is hard to know who influenced who. Thus,
comparing individuals’ and peer outcomes will not provide a causal estimale.
It is hard to distinguish from contextual effects and endogenous effects.

Matthew Robinson 41
8. Immigration
.8.1. Who decides to emigrate and where do they go?
From a destination country’s perspective, it is superior to have immigrants with high productivity
who adapt rapidly to conditions in the host country, thereby making a significant contribution to
economic growth.

()a Immigration investment decision

An immigrant will migrate if they face a positive NPV outcome. Thus, they will immigrate if:
NPV = PV of destination - PV of staying - PV of costs of moving
Those with longer time horizons are more likely to immigrate.
Those who give greater weight to the welfare of their children have a higher propensity tomigrate.

()b ROY model

The Roy Model models whether the destination country is positively selecting (receiving
good/highly skilled immigrants) or negatively selecting (getting bad/low-skilled immigrants)
immigrants.
Assuming the model has earnings on the Y-axis and skills on the X-axis, we can plot the returns on
skill to determine what types of immigrants will migrate. The two countries will intersect at point Sp.
Each country will have a different return to skill; a person will migrate if the return to skill in the
destination country will benefit their skill set. As such, more highly skilled workers will prefer high
returns to skill – steep gradients; lowly skilled workers will prefer low returns to skill (a more
egalitarian society).
If the destination has a greater return to skill, workers with skills above Sp will migrate to the
country, and workers in the destination country with skills below Sp may emigrate (depending on
costs). For the source country, this constitutes a brain drain; they loose skilled workers. This
constitutes positive selection for the destination country.
Conversely, if the destination has low returns to skill, the people who it benefits to migrate will be
low-skilled migrants.
Different average income levels do not change whether a country is positively or negatively
selecting migrants. It does however affect the size of the flow, and at what point (ie skill level) it
becomes advantageous to migrate. For example:
if incomes in the country with the higher returns to skill fall, they will still positively select migrants,
however Sp will be higher meaning that it is only beneficial for people with the very highest skill
level to immigrate.
if incomes in the country with low returns to skill fall, they will still negatively select, but Sp will
reduce, so there is less migration, which is only of the lowest skilled workers.

.8.2. How do immigrants fare in the labour market?

()a Economic Assimilation and Cohort effects
It is generally accepted that over time immigrants will acquire human capital and skills that are
necessary in the host country labour market (ie knowledge of language and culture, education,
training and work experience).
Some evidence indicates that male migrants eventually overtake male natuves.
Empirical evidence suggests that there is a positive correlation between immigrant earnings and
the number of years since immigration. However, caution must be exercised because there is the

Matthew Robinson 42
possibility of cohort effects. For example, if a study looks at waves of migrants entering the host
country in 1960, 1980 and 2000, the cohort may have different attributes which make it difficult to
estimate the benefits from assimilation; namely, if the cohorts have progressively less favourable
attributes, the most recent (2000) immigrants will have much lower earnings, compared to the
oldest (1960) immigrants – the earning differences could be purely attributed to assimilation, rather
than cohort effects.

()b Immigration selection processes

Business Skills and Employer Nomination Scheme immigration have high pariticpation rates (82%)
and low unemployment rates (3%). Other skill-based migrants (ie concessional family) have high
participation rates, but their chance of being unemployed is greater.
Humanitarian immigrants have high levels of unemployment – ie 86% within 6 months and 56%
within 18 months.

()c Ethnic Enclaves

Ethnic enclaves are often said to hinder assimilation. However, such an argument is simplistic.
Relevant factors include:

• slower acquisition of host country skills: an ethnic enclave provides immigrants with less
exposure to natives and therefore hinder their ability to obtain necessary skills and
therefore jobs.

• Network effects: living in enclaves can increase the opportunites for employment because
the enclave disseminates valuable information (about jobs, etc), provides less
discrimination than the rest of the labour market. This therefore improves outcomes.

• Spatial mismatch: The enclave may be in a different place from employment

opportunities, so may be disadvantages.

• Human capital externalities: The unskilled migrants may benefit from being in a group that
includes highly skilled members.
It is difficult to measure the effect of enclaves because selection is unlikely to be random, creating
a bias in results – ie if only unskilled workers go into enclaves, then outcomes may be deemed
negative.
Edin et al (2003) examins the effect of enclaves on assimilation in Sweden. They exploited a
Swedish government policy to randomly place refugees where housing was available (refugees
could leave, but 54% stayed in the same location for at least 8 years). The study found that the
being in an enclave had a positive, but not statisitically significant benefit. They found that those
with less than 10 years of education benefited from being in an enclave. They found that there was
a statistically insignificant result that highly educated people suffered from being in an enclave.

.8.3. What affect does immigration have on native wages and

employment opportunities?
()a Impact on wages – immigrants as substitutes
Perfect market
The increased supply of labour will reduce the wage rate. However this will be more than off-set
by the increased return to capital (producer surplus) – this benefits native firms.
Minimum wage
In the case of a minimum wage, the increased supply of capital does not reduce the wage,
meaning that unemployment rises amongst the natives. Employers receive the same surplus
regardless of whether there is immigration or not.

Matthew Robinson 43
Wage rigidity
In the case of wage rigidity, immigration increases the labour supply, which reduces the wage rate,
but not sufficiently to let the market clear. This means that unemployment rises amongst natives.
This results in employers gaining slightly. It is unclear whether the overall impact is positive or
negative.

()b Immigrants as complements

Where immigrants are complements, they could raise the wages of native workers.

()c Empirical evidence

Empirically, there is very little evidence that immigration has caused significant reductions in native
employment. Most find a 10% increase in the fraction of immigrants in the population reduces
native wages by at most 1%. This even applies to natives who are close substitutes with native
workers.
In the Mariel boat lift 125,000 Cubans were allowed to emigrate to Miami from Cuba. This
increased Miami’s overall labour force by 7% and the low skilled labour force by 16%. The study
of this event found a statistically insignificant reduction in unemployment over the relevant period.
It is suggested that this result is due to:

• native workers changing their location due to the immigration – native workers may leave
the highly competitive labour markets, and/or there may be less domestic migration. For
example, the Miami population grew at 1.4% compared to 3.4% for the rest of Florida.

• Miami was extremely well set up to absorb Cuban immigrants – there were pre-existing
Cuban employment and social networks, local industries had demand for their skills and
the city had been accepting immigrants for decades.

Matthew Robinson 44
9. Labour market policies
.9.1. Types of labour market policies
Active policies aim to increase employment and wages of unemployed people, and include job
search assistance, training, employment subsidies and public sector job creation.
Passive policies aim to increase the material welfare of disadvantaged persons, and include
unemployment and disability benefits.

.9.2. Types of unemployment and job search

()a Frictional unemployment
Even in a market equilibrium where labour supply equals labour demand, there will be frictional
unemployment where people are between jobs. This is caused by the fact that employers and
employees have to match, which takes some time.

()b A model of job search

The amount of frictional unemployment is determined by the speed of matching.
This process is modelled by job search theory.
Assumptions / foundations:

• Employers require a minimum skill level K, and the wage associated with this skill level is
W(K).

• A job seeker has a skill level of K*; the maximum salary the person can achieve is W(K*).

• Information is not perfect, so individuals do not know which firms require the skill set
encompassed by K*.

• Therefore, job seekers will apply to random firms, and will get offered the job where their
hiring standard is ≤ K*.

• However, the person will have a reservation WR, and they will not accept the job.
Under this model, the distribution (shown as a normal distribution) was centred around the the
weighted average of the offers between WR and W(K*). The tails are shaded out because they pay
too little or the required skill is too high.
The job-seeker’s reservation wage will respond to changes in the benefits and costs of search
activities as well as their discount rate. The reservation rate will be in at the intersection of the
marginal cost (upward sloping) and marginal revenue (downward sloping) curves. (dollars are on
the y-axis and wage is on the x-axis).
Workers with high discount rates have less to gain from additional searches, so the marginal
revenue curve shifts leftward, to a lower reservation wage.
Unemployment benefits reduce the marginal cost of the job-search, meaning that the marginal cost
curve shifts-rightward, increasing the reservation wage. Because the reservation wage has
increased, there are less jobs that are appropriate, meaning that the period of unemployment will
be longer.

()c Structural unemployment

Structural unemployment occurs when there is a mismatch between the skills possessed and the
skills required in jobs that are created. This usually reflects underlying changes in the structure of
the economy; it could also arise from job creation in different regions where old jobs are destroyed.

Matthew Robinson 45
This arises because the costs of adjustment are sufficiently high to prevent movements to the new
industry.

.9.3. Active Labour Market Policies (ALMP)

()a Different types
Job broking services aim to help unemployed people locate jobs and improve their skills. It may
involve access to job vacancy databases, assistance in writing a resume, interview training and
placement into appropriate programs.
ALMP may come in the form of training, which is usually classroom training over a short period.
Subsidised employment programs may be in the form of wage subsidies or direct-job-creation.
Wage subsidy schemes involve subsidies for a fixed period to firms to employ particular workers.
Direct-job-creation programs are public programs that employ the unemployed, and usually involve
doing community projects.

()b How AMPLS may affect unemployment?

ALMPs can be modelled using a labour demand curve and a labour supply curve
(called the wage setting curve). They are plotted with the real wage on the y-axis
and business employment on the x-axis.

(b.i) Improve matching

ALMPs may improve matching by adjusting the skill mix of job seekers or enhancing
the effectiveness of job searches.
Reduced vacancy-to-unemployment ratio reduces wage pressure, causing a
downward shift in the wage-setting curve.
Vacancies are costly to employers, so the reduced vacancy-to-unemployment ratio
causes an outward shift in labour demand.
This will tend to raise employment, with an uncertain overall effect on real wages.

(b.ii) Productivity
ALMPs may increase labour force productivity through either training programs or on-
the-job learning in the case of subsidised employment.
The productivity increase shifts the demand for jobs rightward, lifting employment
and wages.

(b.iii) Attachment to the labour force

Increase unemployed workers’ attachment to the labour force.
Stronger competition for jobs would shift the wage-setting curve down, raising
employment and reducing wages.

(b.iv) Subsidised employment

Subsidised employment may increase employment through a both a positive
substitution effect and a scale effect from an overall reductyion in labour costs. This
is represented by a rightward shift in

(b.v) Lower disutility

If workers have a lower disutility of being unemployed (via extra income), they would
demand higher wages during bargaining, shifting the wage setting curve leftward,
reducing employment.

Matthew Robinson 46
()c Deadweight losses and displacement and substitution effects
Subsidised employment programs are sometimes criticised because of:

• deadweight loss – a proportion of the people would have been employed anyway

• substitution effect – a proportion of the people will take the place of other people who
would have been employed in the absence of the subsidy.

• displacement effect – other employers may shed labour if they don’t qualify for the subsidy
to retain competitivemenss.
An OECD review of Australia’s JobStart scheme estimated the deadweight loss as between 67
and 79%.
Thus, wage subsidy and job-creation programs are generally considered to be high cost, low
benefit. But it comes down to a political decision as to whether the redistribution of opportunities to
a particular group are worth it.

()d Lock-in effects

There is always a risk that people will reduce job search during the program.

()e Evaluation of ALMPs

It is difficult to analyse the effect of ALMPs because of two-way causality – ALMPs may increase
employment, but the prevalence of ALMPs may increase during periods of high unemployment.
Therefore, most evaluations are microeconomic. Effectively, researchers seek to measure the
difference in labour market outcomes of participants and non-participants.
This is often difficult because of selection bias – ie people are likely to positively self-select into
ALMPs, resulting in an upward bias. Further, administrators will often select the best candidates
because of rewards for successful outcomes.
Data from social experiments where you have a treatment and control group will often have high
internal validity, but low external validity.
To counteract selection bias, researchers use a process of matching – they use criteria that
attempt to capture all observed and unobserved variables to match a person in the control group
with one in the treatment group. However, problems can arise here due to the curse of
dimensionality, whereby the more criteria that are used, the harder it is to match people. An
alternative method is to use a participation probability /propensity score.

.9.4. Australia’ work for the dole

Participation in work for the dole may have two effects:

• participation directly affects individuals’ likelihood of employment

• referral to work for the dole cause people to exit welfare payments when they would be
required to begin – governments hope this effect is minor.
The empirical study matched a treatment and control group by a number of factors that resulted in
people being able to be classified in one of 3,369,000 cells. It was possible to match 802 work for
the dole participants to control group individuals. The weighted average of cell differenes is taken
as the overall average effect of work for the dole participation.
Figures showed that more than a third of participants were in employment or education 3 months
after completion.
It did seem to have a positive effect on receipt of welfare payments.

Matthew Robinson 47
.9.5. Other empirical findings
Job broking:

• appears to improve labour market outcomes

• main effect seems to be increased job search intensity

• most effective where do not distrort the type of job search and where labour demand
conditions are most favourable
Training:

• effectiveness depends on ability to deliver skills that are in demand – if there is a poor
match, the lock-in effect is likely to dominate.

• Effect of training is more evident over time

Subsidised employment:

• usually leads to negative general equilibrium effects, with high costs

• least skilled individuals derive the most from these programs, probably because it gives
them the ability to acquire work skills.

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Economic growth (Jay)
10. Introduction
{not examinable}

11. Neoclassical / Solow model

.11.1. Solow model
()a The steady state
Assumptions:

• Positive but diminishing returns to capital and labour

• Contstant returns to scale

• Exogenous investment rate

• Exogenous population growth

• Exogenous rate of technological progress.

The model predicts that an economy will move to a steady state, such that:
sy* = (n + g + d) k*
Amount of income saved = capital/effective labour x (population growth + technological growth + depreciation)

At steady state, there is no movement from this equilibrium, unless one of these factors change.

()b Transition dynamics

If the capital stock per unit of effective labour (k) is less than the steady state capital stock (k*),
savings/investment exceeds the depreciation term (n + g + d), meaning the growth in k > 0.
Conversely, if k > k*, then the depreciation term will erode the existing capital stock meaning the
growth of k < 0.
The rate of growth will be greater the further away k is from k*.

()c Conditional & absolute convergence

The Solow model does not predict that there will be absolute convergence – ie it does not expet
that countries will end up with uniform GDP per capita.
However, it predicts that conditional on a country having the same parameters (ie population
growth, technology, capital and labour), poorer countries will grow faster to catch up to their steady
state.
This implies that the coefficient for the output gap will be negative in any regression.
Convergence appears to hold for OECD countries, however non-OECD countries do not appear to
exhibit convergence.

.11.2. Mankiw, Romer and Weil (MRW) & criticism

()a Steady state, effected by k* and depreciation?
According to the Solow model, the steady state (y* & k*) will increase with savings and decrease

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with depreciation.
They find that:

• Coefficients have expected sign and are statistically significant.

• 59% of cross-country variances in GDP per worker can be explained by the steady state
variables

• The magnitude of coefficients are too large – ie α = 0.6, implying that 60% of income goes
to capital.

()b Speed of convergence

The Solow model predicts that the economy will converge to its steady state, with growth falling as
income rises.
MRW state that the Solow model predicts a convergence rate of 4%. However Barro and Sala-i-
Martin estimate the speed of convergence to be approximately 2%. This is only half the rate
predicted by the Solow model.

.11.3. Overview of weakness

It appears although the Solow model is internally valid, but may not be externally valid. The
predictions do not match the quantitative observations, namely:
Capital share is too high (near 60%)
The rate of convergence is about 2%, which is half what is predicted by the model
Observed interest rate differentials and international capital flows much lower than model
predictions.

.11.4. Improvements to the model

To cure these problems, it may be possible to:

• Include a human capital accumulation term into the model.

• Incorporate spill-over effects from capital investment – capital investment is posited to

generate positive externalities for related industries.

()a Augmented Solow model – human capital accumulation

Human capital is assumed to accumulate in a similar way to physical capital, so it can be modelled
similarly. The production function can be stated as: Yt = Ktα Htβ (AtLt)1-α-β , α + β < 1
In the same way that capital accumulates, human capital accumulation is:
Ht = SH Yt - dHt
where:

• Ht is the stock of human capital

• SH is the saving / investment in education

• d is the depreciation of human capital.

MRW estimate that α = 1/3 and β= 1/3. They use this re recalculate the speed of convergence and
find that it results in a speed of convergence of 2% which is much closer to empiric results. They
find that this augmented model captures 80% of country differences at steady states.
However, the Solow model explains the level difference better than the growth difference. The
method of MRW is criticised for not taking into account initial technology levels, and because it is
Matthew Robinson 50
not as accurate for OECD countries because there are little variation in steady state variables.

Matthew Robinson 51
12. Easterly & Levine’s 5 stylised facts
.12.1. TFP is responsible for growth
Total factor productivity can be interpreted in a number of different ways, including externalities in
factor accumulation, adoption of lower costs of production and technological spill-overs. From a
regression point of view, TFP is basically the residual.

()a Growth accounting

Growth can be broken down into its individual components pursuant to the cobb-douglas (or other)
production function.
Empirical evidence has suggested that capital accumulation has accounted for a relatively small
proportion of growth (12 – 25%), while TFP has accounted for over 50% of growth.
Evidence suggests TFP is larger for countries that are growing faster.
Incorporating human capital does not affect this.
The problem with growth accounting is that it does not imply causality, nor does it test the
statistical significance of output growth and capital growth.

()b Variance-decomposition approach

The variance-decomposition approach attempts to measure the relative importance of variables by
determining how much the variance in the independent variables effect variance in output.
Results seem to indicate that the variance in output is attributable to TFP more than 60% of the
time; cf capital which is not often above 25%.

()c Level accounting

{don’t know what the thing to take out of this is}

.12.2. Divergence in per capital income over time

Growth rates of ‘rich’ countries have not slowed over the past century – this implies that there is
something else driving growth. Meanwhile, some poor countries have grown slowly, if at all. This
appears to contradict the idea of convergence (but only in its absolute form).

.12.3. Factor accumulation is persistent, but growth is not

Economic activity is characterised by booms and crashes, but this is not evidenced in factor
accumulation. Conversely, TFP growth is not persistent.
Evidence suggests policy differences are more persistent than growth differences across
countries. This may indicate that changes in policy may only have a temporary effect on a
country’s growth rate, until they reach the technological frontier. It is is possible that growth
miracles were caused by good policies, and growth disasters by poor policies.
Factor accumulation is persistent. This may be because schooling may respond to an expected
policy over a future working life, and physical capital will also have a relatively long term life.
Conversely, TFP is more subject to current policy because the private returns are shorter-lived
(subject to IP laws).

Matthew Robinson 52
.12.4. Economic activity is highly concentrated
Economic activity is concentrated. EL suggests that if there was no differences in TFP, factors
would spread out evenly. However, the fact that this does not happen may be due to technology
and externalities.

.12.5. National policies care closely associated with long term

economic growth
Economists disagree as to whether national policies are strongly linked with growth.
Openness to trade and financial development have been strongly related with growth.
EL show country growth rates are correlated with country policy variables, even after controlling for
endogeneity (reverse causality) by using lagged variables (but lagged variables can still suffer from
causality problems because it may influence future expectations).
The data showing greater growth may just be exhibiting temporary responses to policy.
Thus, policy may affect output levels, but may not influence growth rates beyond an initial
movement to a higher level.

Matthew Robinson 53
Exam preparation
13. Sample questions from blackboard
.13.1. PART ONE
A PhD student is interested to explore whether state efficiency has an impact on tax compliance.
a) Discuss in detail what research methods the PhD student could use to investigate this
question.
b) What are the advantage and shortcomings of the suggested methods to answer this
research question?
c) The PhD student wonders whether it is possible to develop a theoretical model that allows
to explore the impact of state efficiency on tax compliance. Please develop such a model.

.13.2. PART TWO

Should monetary policy be conducted in terms of rules rather than discretion? Discuss.

.13.3. PART THREE

a) Females attending single sex schools perform better academically than females attending
coeducational schools. With reference to the economics peer effect literature, discuss possible
explanations for this result.
b) Discuss how ethnic enclaves can affect the economic assimilation of immigrants.

.13.4. PART FOUR

a) Policy changes in the Solow-Swan model have no long run growth effect. Elaborate.
b) Why do economies exhibit sustained growth in the Solow-Swan model?
c) According to Easterly and Levine (2001), what is the principal determinant of long run growth?
Briefly comment on two loopholes in their argument.

Matthew Robinson 54
My Essay
Introduction
The positive impacts that education has on the individual and economy are unquestioned.
Consequently, economic, social and political considerations necessitate a close analysis of
whether higher education is equally accessible to all Australian citizens. Australian evidence
suggests that low socio-economic status (“SES”) students are half as likely to participate in higher
education than their medium and high SES counterparts (“SES Inequality”) (James, 2002). Given
this inequality, eliminating SES Inequality to ensure an egalitarian and productive society,
constitutes a unique policy challenge for the Australian Government.
This essay establishes the existence of SES Inequality in Australia’s tertiary sector and why the
problem must be combated. It then briefly sets out policies that finance students’ university
attendance. The paper proceeds to a critical analysis of full tuition-fee scholarships, having regard
to its likely success in reducing SES Inequality. Finally, the authors consider alternative policies.
Australia’s education system and low SES disadvantage
More than one million people are currently undertaking study at one of Australia’s higher education
institutions, with more than 650,000 of these receiving government assistance towards their
education (Department of Education, Employment and Workplace Relations, 2008). Despite 25%
of the Australian population being low SES, over the preceding two decades low SES students
have consistently only made up 15% of the student cohort (James, 2002; Department of
Education, Employment and Workplace Relations, 2009). This indicates significant educational
disadvantage for low SES individuals.
SES Inequality is a legitimate ground for government intervention due to the economic and social
externalities generated by education. Higher education is a key factor in human capital
accumulation and is strongly tied to a nation’s economic growth (Jones, 2008). There is also
strong evidence linking education to increasing civil citizenship, reduced crime and increased
social mobility (McTaggart, Findlay, & Parkin, 2007).
Furthermore, there are a number of other private and public returns to higher education including,
inter alia, superior health, welfare, self esteem, parenting skills and social tolerance (Murray,
2009). Importantly, recent studies have found that the positive externalities associated with
education are greatest in the case of disadvantaged groups (including low SES), through
increased social cohesion and resilience (Murray, 2009). Therefore, it is clear that equal access to
higher education must be a high priority for policymakers.
SES Inequality has persisted in Australia despite the introduction of the first income contingent
loan system, the Higher Education Contribution Scheme (“HECS”), now the Higher Education Loan
Program (“HELP”) (Le & Miller, 2005). HECS-HELP is a sophisticated universal student financing
system, whereby the Government subsidies the tuition costs of students and imposes a student
contribution in the form of a contingent liability extracted through the tax system (Chapman &
Ryan, 2005). The student repays the debt once his or her income is above the prescribed
threshold. This means the risk is shared between the taxpayer and student. The success of
HECS-HELP spurred the United Kingdom and New Zealand, among others, to adopt income
contingent loan schemes (Chapman & Ryan, 2005).
Moreover, the existence of Youth Allowance and Austudy (“Income Support”) is important,
because it provides means-tested fortnightly payments to university students. Both Income
Support and HECS-HELP are seen to be essential to internalising the externalities generated by
higher education, and reducing credit constraints.
Australia’s policy settings provide a base level of income while at university that reduces the
quantum of forgone earnings, while deferring the tuition fees until individuals are benefiting from
tertiary education. These policies are incorporated into the model of university attendance below.

Will scholarships reduce SES Inequality?

Matthew Robinson 55
Why do people educate themselves?
An individual’s income is predicted to increase by 7% for each year of higher education (Jones,
2008; Perna, 2005). However, this does not dictate that a person will pursue tertiary education.
People are assumed to treat education as a net present value (“NPV”) investment decision,
whereby a person will educate themselves where the marginal benefits exceeds marginal costs,
adjusted for their discount rate. The stylised model in Figure 1 can be adapted to take into account
the HECS-HELP and Income Support available to low SES students in Australia (see Figure 2).
This framework informs the remainder of the essay.
Figure 1: The costs and benefits of tertiary education over a lifetime

Figure 2: The costs and benefits of education for Australian low SES students

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The scholarship program considered
The essay assumes that the tuition scholarship program (“Scholarship Program”):

• is only available to low SES individuals;

• requires potential students to apply;

• is awarded on the basis of SES and academic ability;

• pays all fees levied by the university;

• does not provide further financial assistance.

Will a Scholarship Program reduce SES Inequality?
Scholarship Programs are posited to reduce SES Inequality the funding eliminates credit
constraints - an inability to finance the costs of education – or turns higher education into a positive
NPV investment. To examine the effectiveness and efficiency of a Scholarship program, this part
examines whether it would mitigate credit constraints or change marginal investment decisions,
and whether SES Inequality is in fact caused by a credit constraint.
Firstly, the Scholarship Program reduces the cost of repaying HECS-HELP later in life, but ignorers
the immediate costs of higher education. Although this increases the NPV of the investment
decision (although the extent may be minor depending on the student’s discount rate), it does not
reduce the present costs of tertiary education, meaning that it does not alleviate credit constraints.
Chapman and Ryan (2005) find that the introduction of HECS did not deter low SES students from
attending university; this indicates that the removal of a HECS-HELP debt through a Scholarship
Program is unlikely to eliminate credit constraints, nor see students’ education decisions change
from negative to positive NPV investments.
The foregoing analysis fails to consider the concept of eligibility. Even if university attendance
represents a positive NPV investment decision, poor prior academic achievement may preclude a
student from admission to university. Cardack and Ryan (2009) find that after controlling for
academic achievement, low socio-economic individuals are not under-represented in tertiary
education. This finding appears robust, with similar results exhibited internationally (Galindo-
Rueda, Marcenaro-Gutierrez and Vignoles, 2004), despite some evidence of small credit
constraints in the UK and US (Dearden, McGranahan, & Sianesi, 2004; Carneiro & Heckman,
2002). Cardak and Ryan (2009) interpret their results to indicate that low SES students are not in
fact credit constrained, rather that their prior academic performance is responsible for their non-
attendance at university.
Therefore, the Scholarship Program is unlikely to reduce SES Inequality due to the ineligibility of
many low SES individuals and the possibility that the scholarships will not materially affect
students’ investment decisions or alleviate the credit constraints (if any) experienced by students.
Alternative policies to equalise access to tertiary education
This section canvasses alternative policies aimed at reducing SES Inequality.
If, contrary to Cardack and Ryan (2009), a portion of students are in fact credit constrained, a
program that reduces the upfront costs of attending university is likely to have a greater impact.
This could either be delivered through greater Income Support, or extending income contingent
loans to living expenses (Bradley et al, 2008). This approach recognises that low SES students
may incorporate higher discount rates into their investment decision due to, inter alia:

• an up-bringing that does not emphasise the benefits of education, leading to a short-
term focus; and

• reliance by a student’s family on his or her income, making immediate foregone

earnings more valuable (Bradley et al 2008, 47).
However, practicalities preclude these policies being effectively targeted at marginal (Bradley et al,

Matthew Robinson 57
2008). Thus, providing support to offset the initial costs of education is unlikely to be a cost
effective solution to SES Inequality due to its prohibitive cost and the small or non-existent
influence of credit constraints.
Cardak and Ryan (2009) find that ineligibility for university is correlated with a student’s SES.
Consequently, addressing the poor prior academic achievement of low SES students is a vital
policy consideration. The effects of low SES on education achievement are seen by Grade 9
(Cardak & Ryan, 2009), and may be evident as early as pre-school and primary school (Chowdry
et al 2010). Early interventions that:

• involve quality early learning education;

• are ongoing;

• are staffed by highly qualified individuals

• are of high intensity; and

• involve parents;
are posited to substantially improve non-cognitive skills that are essential to enabling students to
become eligible for university, counteracting the disadvantage suffered by low SES students
(Knudsen et al, 2006; Heckman, 2000). This is consistent with neurobiological evidence (Knudsen
et al, 2006) and the notion that learning begets learning (Heckman, 2000).
Further, structural changes to early, primary and secondary education is suggested as a cost
effective method of decreasing SES Inequality. Changes may include, increased transparency in
the public education system, introducing performance pay for teachers and increasing competition
between schools (Heckman, 2000). However, programs to reduce class sizes are unlikely to
return sufficient benefits to justify the substantial costs involved (Heckman, 2000). Other possible
policy responses include outreach programs between schools and universities, as well as
communicating of the benefits of education to low SES students and their families (Bradley et al,
2008; Milbourne & Bajada, 2008).
Finally, it is naïve to rule out non-institutional factors as a contributor to the problem. The family
unit, and their attitudes towards education, can have an important impact on students’ educational
development, aspirations and preferences (Heckman, 2000). Therefore, fostering an aspiration to
attend university and reducing perceived barriers to entry into university are further policy objective
that should be pursued to reduce SES Inequality (Dearden, McGranahan, & Sianesi, 2004).
Conclusion
It is clear that the alleviation of SES Inequality is a policy challenge, the resolution of which would
return significant positive externalities for Australia. However, the challenge cannot be solved by
implementing policies at the point of entry to university through tuition scholarships; if a small credit
constraint exists in Australia, it is unlikely to be solved by a Scholarship Program. Instead, a
holistic approach to education must be adopted, with a focus on the formative years of low SES
students’ education, promoting an aspiration to attend university and reducing perceived
inequalities.

Matthew Robinson 58