I ended my last post suggesting that it is absurd to provide pensions that are not subject to means tests because this involves taxing people of working age more heavily in order to add unnecessarily to the incomes of wealthy retirees. This raised the question of whether the elderly poor are likely to fare better in the context of the looming pensions crisis in OECD countries under means tested pensions or universal benefits.
This question is most relevant in countries that have not already adopted some form of pay-as-you-go universal aged pensions. Path dependency is involved. Once a country goes down the universal pensions path there are substantial political difficulties in back-tracking because this system encourages each generation of retirees to expect rewards for the taxes they have paid to support the preceding generations of retirees.
I expect that the political economy of how the elderly poor are likely to fare under alternative systems has been researched previously, but I haven’t yet found any papers that are directly relevant. So I will attempt to sketch out some preliminary ideas, based heavily on Australian experience.
One factor that will influence how the elderly poor fare under alternative pension arrangements will be their own political power as a group. This seems to vary greatly between countries depending on such factors as their use of voting rights. The presence or absence of means-testing could make an additional difference to the political power of this group since it identifies pensioners as a particular group of elderly people who have a common interest in lobbying for higher pensions. In that respect, means testing causes the interests of the elderly poor to differ from those of other elderly people.
Pension levels of the elderly poor are also likely to be influenced by the way the political objectives of other elderly people (and of middle-aged people who are planning for retirement) evolve under different systems. Peter Lindert’s analysis of the political economy of the public pension crisis seems to provide a good starting point to consider this. He summarises as follows:
‘At first, up to the 1980s, the rise of the elderly population gave the elderly more political clout in the industrialized OECD countries. The rise in their political strength was one reason why the relative generosity of pensions rose and budgets switched from fully funded pension systems to pay-as-you-go systems, giving one lucky generation higher pensions paid for in part by the younger generation. By the 1980s, the pressure on government budgets had become acute.
From that point on, the further rise in the elderly share of population began to undermine their political strength. True, pension budgets are not declining and are projected to rise a bit more as a share of GDP. Yet, the level of pension support per elderly person is destined to go on dropping as a percentage of the average income of the whole population’ (‘Growing Public’, Vol. 1: 208).
As the number of retirees rises relative to numbers of people in the workforce, their interests are increasingly aligned with those of the community at large in maintaining incentives for the goose to continue laying golden eggs. If excessive demands by retirees result in higher tax rates the adverse consequences for economic growth will be reflected back in their future pension levels.
The demographic transition stemming from lower birth rates and increased longevity is far more advanced in some countries (e.g. Sweden) than in others (e.g. Australia). Signs that the increase in the elderly share of the population may be beginning to undermine their political strength are only now beginning to appear in Australia, with a foreshadowed increase in the age of eligibility for pensions.
Australian experience suggests that when the aging middle classes have political clout they can exercise it to look after their own interests despite means tests for aged pensions. The relaxation of means tests, combined with tax concessions to encourage investment in private superannuation, has resulted in total government support for retirees being remarkably similar across a wide range of income levels (shown here). This suggests that total government support for retirees would be much the same under a flat rate universal system without incentives for private superannuation. Complicating matters further, however, the government has allowed people to access tax-privileged superannuation funds in lump sums prior to pension age. This has provided an added incentive for people to retire early, splurging lump sums and living off accumulated wealth until they become eligible for the aged pension.
As the increase in proportion of elderly people in the population in Australia reduces the per voter political power of this group, I would expect the per voter political power of the elderly poor to diminish to a smaller extent than that of the much larger group who hope to benefit from the private superannuation tax and pension means test rorts. I expect incentives for early retirement implicit in the superannuation arrangements will be an early casualty as attempts are made to contain government spending on retirees. If a choice has to be made at some time in the future between, say, maintaining the current level of the aged pension in real terms and maintaining superannuation tax concessions, I expect that maintaining the aged pension levels would be likely to win the political debate. Similarly, given a decline in grey power on a per voter basis I doubt whether superannuation tax concession would win the political debate if a choice has to be made at some time in the future between maintaining these tax concessions and an overall lowering in income tax rates to promote economic growth.
I suspect that the elderly poor would be less able to protect their interests under a universal pension because the support arrangements would not enable them to distinguish themselves as a group whose economic interests differ from those of other elderly people.
At 8:30 AM EDT, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 459,000 new jobless claims last week, which would would be 6,000 less than last week’s higher than expected number.
Also at 8:30 AM EDT, the final GDP report for the second quarter of 2010 will be announced. The consensus is an increase of 1.6% in real GDP and an increase of 1.9% in the GDP price index. The real GDP estimate is the same as the preliminary estimate for this quarter from last month, and the GDP price index estimate is rising due to increasing import prices.
Also at 8:30 AM EDT, the Corporate Profits report from the Bureau of Economic Analysis will be released.
At 9:45 AM EDT, the Chicago PMI Index for September will be announced. The consensus index value is 56, which is 0.7 points lower than last month, but is still well above the break-even level at 50.
At 10:00 AM EDT, Ben Bernanke will testify before the Senate Banking Committee on implementing Dodd-Frank reforms, along with Neal Wolin, Sheila Bair, Mary Schapiro and Gary Gensler.
At 10:30 AM EDT, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.
At 2:30 PM EDT, Ben Bernanke will lead a town hall meeting with educators and take questions from all around the country.
At 4:30 PM EDT, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.
Also at 4:30 PM EDT, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.
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In the course of economic growth theory, the impact of religion on economic growth and GDP per capita has been largely neglected by the mainstream economic theory. Basically, there have been two major conceptual forces behind the demonstration of the effect of religiousness on economic growth. First, traditional theoretical approach to the analysis of economic growth embodied in the Solow approach emphasized the role of capital accumulation and technological progress in the growth of total factor productivity where the technological progress accounted for the unexplained and exogenous feature that drove the growth of total factor productivity.
Early analysis of economic growth and its main determinants heavily neglected the effect of institutional variables on economic growth. Second, the theoretical framework of economic growth usually follows the empirical evidence on the existence of postulated hypotheses related to the economic growth. Primarily, the effect of religion and other institutional features on economic growth has been displaced to the lack of empirical estimation techniques that could account and control for the effect of the institutional phenomena on the course of economic growth.
The best lucrative and empirically consistent analysis of economic growth and its determinants had been documented by Robert Barro and Xavier Sala-i-Martin. In 2004, Robert Barro published Economic Growth Across Countries. In the explanatory framework, the author included several institutional variables and examined its effect on 10-year economic growth interval in a cross section of 86 countries over 1965-1975, 1975-1985 and 1985-1995 time periods. For a given set of institutional control variables, the rule of law exerted a strong, positive and statistically significant effect on growth. The effect of democracy, the second institutional control variable, was estimated by a single coefficient and its squared term to account for a possible movement of the effect of the level of democracy.
The magnitude of both coefficients was statistically significant. The sign of the squared term was negative suggesting for a typical inverted-U effect of democracy on economic growth. In the meaning of the economic theory, the estimated coefficients suggested that the adoption of democratic institutions and policies in the initial stage of GDP per capita boosts economic growth, particularly by the institutions such as the rule of law, electoral representation, and multiparty political system as well as by the constitutional protection of civil liberties.
However, as countries depart from the initial level of GDP per capita, the political pressure from electoral representation tends to enforce egalitarian policies that negatively effect economic growth, particularly by the fiscal redistribution of income to mitigate income inequality. Consequently, the effect of democratic institutions tends to diminish and, as the curve bends, the predictive effect of constitutional democracy is negative, thereby exerting a negative effect on economic growth. However, the hypothetical relationship between democracy and economic growth is dubious, if not intriguing. In fact, neoclassical growth theories suggest that the rate of economic growth tends to diminish alongside the expansion of the capital stock and productive capacity of the national economy. The hypothesized theoretical assertion postulates that the non-linear, inverted-U effect of democratic institutions on economic growth is overestimated.
In 2003, Robert Barro and Rachel M. McCleary wrote a seminal contribution (link) to the theory and empirics of the relationship between religion and economic growth. Even though in The Protestant Ethics, Max Weber argued that the religious practices and beliefs have had important implications for economic development, the economists paid little or no attention to the role of religiousness as a cultural measure on economic growth. Arguably, the most difficult inferential problem in economic theory is to capture the direction of causality in non-experimental data which indistinguishably confuses the empirical inference from sample estimates. The theoretical relationship between the religion and economic growth is nonetheless a daunting task of the economic theory.
Across the world, there is a whole spectrum of religious diversity in the interplay between religion and economic development. Some countries, such as the United States have been largely influenced by the Enlightenment thought, penned in Thomas Jefferson’s 1779 The Virginia Act for Establishing Religious Freedom, on religious freedom as the principle of freedom from religious oppression. On the other hand, countries in Northern and some parts of the Continental Europe largely adopted Protestantism as the religious establishment while Southern and Central European countries experienced a strong and coercive influence of Roman Catholicism. Hence, the historical bond of nations in the Middle East and North Africa to the Islamic religion accounts for a significant share of the world population and a representative estimate of the effect of Islam on economic growth.
In addition, many political regimes, particularly in China, Soviet Union and Cuba, have attempted to suppress the religious freedom and, hence, establish a system that officially prohibited and punished the religious practice. Surprisingly, countries in Northern Europe such as Norway, Finland and Iceland have established an official religion that is effectively articled in the constitution. Given the vast difference in the distribution of GDP per capita across countries, the assessment of the relationship between the religion and economic growth is not a triviality per se.
Robert Barro and Rachel M. McCleary constructed a broad cross-country dataset which included national account variables and an array of other political, economic and institutional indicators in a cross section of over 100 countries since 1960. The predicted theoretical expectations postulate whether the religion fosters religious beliefs that influence individual cultural characteristics such as ethics, work and honesty. The authors estimated both the effect of different explanatory variables on religious outcomes such as monthly church attendance, the belief in heaven and the belief in hell.
The estimated coefficients suggest that monthly church attendance is strongly affected by urbanization rate and a set of dichotomous religious variables. In particular, a one percentage point increase in the urbanization rate decreases monthly church attendance rate by 1.49 percentage points, holding all other factors constant. In addition, a 1 percentage point increase in religious pluralism fosters the monthly church attendance rate by 1.35 percentage points, ceteris paribus, while the increase in the measure of the regulation of religion by 1 percentage point decreases the church attendance rate by 0.64 percentage point. Hence, the church attendance rate in countries with official state religion, on average, increases the religious participation by 0.87 percent more compared to countries with the absence of state religion, ceteris paribus. The belief in heaven and hell, on the other hand, is positively correlated with state religion and religious pluralism, Muslim religious faction and other religious factions. The belief in heaven and hell is significantly negatively correlated with urbanization rate, communist regimes, Orthodox religion, Hindu religion and Protestant religion. Barro and McCleary regressed growth rates of real GDP per capita on variables of monthly church attendance rate, belief in heaven, belief in hell and dichotomous (dummy) religious variables representing the share of religion in the countries observed. The table below reports dummy coefficients of each religion relative to the Roman Catholicism. The sign of the coefficient is negative suggesting the increase in the share of each religion (see table) decreases the growth rate of real GDP per capita by less than by the anticipated increase in the share of Roman Catholic religion.
The effect of religion on long-run economic growth
Source: R. Barro & R.M. McCleary: Religion and Economic Growth, 2003.
The p-value for religion shares in the regression specification is about 0.001, suggesting that the hypothetical zero simultaneous effect of the explanatory dummy variables of religious share is easily rejected at 0.1 percent level of statistical significance. The estimate suggests that religious shares influence the growth rate of real GDP per capita. Interestingly, sample estimates of regression coefficients suggest that monthly church attendance is significantly negatively related to the GDP growth rate. The estimated coefficient suggests that higher church attendance will, on average, lead to significantly lower growth rate of real GDP per capita and, hence, a lower growth of the standard of living.
On the other hand, the sample estimates of growth regression coefficients suggest that the extent of belief in heaven and hell is positively related to economic growth. Thus, the empirical evidence from the panel of over 100 countries since 1960 suggests that the belief in heaven and hell encourage ethical behavior and honesty and thereby simultaneously increases the growth rate of real GDP per capita. The reported p-value for church attendance and beliefs is 0.000, suggesting the rejection of null hypothesis on a simultaneous zero effect of church attendance and beliefs in hell and heaven on the growth rate of real GDP per capita, and a strong influence of religious factors on the distribution of economic growth across countries since 1960.
The empirical evidence of the relationship between religion and economic growth suggests that the church attendance and the rate of economic growth are substitutes, not complements. The philosophical premises of Roman Catholicism often scrounge individualism and personal liberties and encourage collectivist mentality by punishing individual work, thrift and effort. Incidentally, the empirical evidence suggests strongly negative effect of the share of Roman Catholic religion on the long-run growth rate of real GDP per capita.
Regarding the true importance of religious freedom, not oppression, on the emergence of order alongside the abstract rules and the pursuit of individual liberty, Friedrich August von Hayek wrote in The Constitution of Liberty: “It should be remembered that, so far as men’s actions toward other persons are concerned, freedom can never mean more that they are restricted only by the general rules. Since there is no kind of action that may not interfere with another person’s protected sphere, neither speech, nor the press, nor the exercise of religion can be completely free. In all these fields … freedom does mean and can mean only that what we may do is not dependent on the approval of any person or authority and is limited only by the same abstract rules that apply equally to all.”
In the microeconomic perspective, religious market is highly oligopolistic, especially in Europe where government subsidies to large religious groups discourage the entry of competitive religions in the market. Therefore, in strongly Catholic countries, such as Italy and Spain, Roman Catholic church firmly resembles the behavioral pattern of a dominant firm, facing price inelastic demand and price elastic supply. Subsidies to churches do not quite differ from subsidies to corporations and enterprises – the net effect are lower marginal costs, increasing the total producer surplus of the church and increasing the deadweight loss to the consumers of religious services. A cautionary approach would require not only the precise modeling of the religious market upon the theoretical assumptions but also the contestable empirical evidence on the existence of the Catholic church as a dominant firm in highly oligopolistic religious market.
Incidentally, the empirical evidence suggests strongly negative effect of the share of Roman Catholic religion on the long-run growth rate of real GDP per capita. Nonetheless, religion is an important determinant of economic growth. However, the evidence from the second half of the last century suggests that the prosperity and wealth of nations is greater if people allocate fewer resources to the exercise of religious activities.
The Mortgage Bankers’ Association purchase index was released at 7:00 AM EDT, and there was a week to week increase of 2.4% in the Purchase Index and a week to week decrease of 1.6% in the Refinance Index as interest rates remain near record lows.
At 10:30 AM EDT, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.
At 3:00 PM EDT, the Farm Prices report for September will be released, giving investors and economists an indication of the direction of food prices in the coming months.
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P. Vaidyanathan Iyer has a great first draft of history, in the new Sunday magazine that goes with the Indian Express, telling the story of what happened in India in late 2008.
This was a difficult period with 6 shocks hitting us in a short time period:
- The Lehman failure,
- The crisis on the money market,
- Difficulties at some banks,
- Difficulties in some mutual fund schemes,
- The Bombay attacks, and finally
- The Satyam crisis.
Things could have turned out much worse. The individuals at MoF, SEBI, and RBI really came together and delivered. As India becomes a more complex economy, it becomes more and more important to bring top quality skills into policy making. The Indian success of crisis management in late 2008 is tightly linked to India’s success on the great conflicts over appointments in 2008. Reading Vaidy’s article made me go back into September and October 2008 on this blog to see what I was thinking and writing at the time:
- On 25 September, I did a lunch talk on the crisis at DEA.
- On 29th September evening, murmurs about difficulties at ICICI Bank erupted after the Indian market closing time. I remember how, late in the night of the 29th, I watched the ICICI ADR trade in the US, saw nothing big happening, did some Merton model calculations, and thought we were okay. The next morning, I wrote this blog post on ICICI Bank.
- This was the first day of the 3rd Research Meeting of the NIPFP DEA Research Program. Those present will remember how the crisis made for a dramatic backdrop for the inaugural session and indeed the entire conference.
- On 6 October I started seeing the liquidity crisis coming together.
- On 10 October, I wrote about the remarkable collapse in the money market which had come about. From 13 October onwards, I started doing a series of Crisis Watch posts.
- From 10 October onwards, Jahangir Aziz, Ila Patnaik and I started writing a paper on what was going wrong and what should be done. Our paper was emailed out on 14th, we did a meeting at NIPFP to discuss it on 18th, and finalised it on 20th.
- On 26th October, I wrote about the short selling question.
When I look back, I feel that (of all people) the NIPFP Macro/Finance Group should have quickly and clearly understood the
linkages between multinationals and the money market, and how the collapse of the money market in London in late September would surely matter greatly to India. We had the building blocks: We truly get India’s high de facto integration into global finance,
and we truly get the rise of Indian multinationals as a game changer. But we weren’t cool enough to connect these pieces and make
the consequent inferences to a surprising conclusion. We only woke up when it was obvious that the Indian money market had
When I look back, the really hard thing at that time was the `fog of war’ which envelops economic policy thinking. In the best of times, the Indian statistical system is weak, and at a time like that, the data was hopelessly out of date. We’re being penny wise + pound foolish in ignoring the informational foundations of the economy, without which policy makers are forced to fly blind. We do this by tolerating an awful statistical system, and by preventing the financial markets which produce vital information.
There was a lot of drama and loud opinions, but it was very hard to figure out what was actually going on. I was also quite concerned
about Indian CEOs crying wolf in order to get money from the government, given the long history of Indian CEOs not knowing how to
make an honest living. So I was biased in favour of ignoring the cries at first.
At 7:45 AM EDT, the weekly ICSC-Goldman Store Sales report will be released, giving an update on the health of the consumer through this analysis of retail sales.
At 8:55 AM EDT, the weekly Redbook report will be released, giving us more information about consumer spending.
At 9:00 AM EDT, the monthly S&P/Case-Shiller home price index report will be released. Given that most economists don’t expect the overall U.S. economy to improve until housing prices end their decline, the market will be watching this number closely.
At 10:00 AM EDT, the monthly report on Consumer Confidence for September will be released. The consensus index level is 52, which would be a 1.5 point decrease from August’s number.
Also at 10:00 AM EDT, the State Street Investor Confidence Index will be released, which looks at changes in the amount of equities held in the portfolios of institutional investors.
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One more top quality order by SEBI. Bhave’s SEBI has really set new standards for the quality of orders.
The OECD recently published the international comparison of the gap in employment rates between university graduates and workers with secondary education or less (link). There is no single exception to the fact that the employment rate is the highest in the group of individuals with college and university degree. Nonetheless, the comparison of the variation in employment rate in the cross section of OECD countries is very interesting.
Among the OECD countries (link), Iceland enjoys the highest employment rate (94.7 percent) of those with college or university degree followed by Switzerland (93.9 percent), Norway (92 percent) and Denmark (91.4 percent). The lowest employment rate for university graduates in 2008 was in Turkey (81.4 percent), Italy (86.5 percent), Israel (86.6 percent) and Greece (87.2 percent). In contrast, the employment rate for those below the secondary education is the lowest in Slovakia (39 percent), Hungary (47.5 percent), Poland (55 percent) and Czech Republic (57.4 percent).
The persistence of high unemployment rate for those below the secondary education degree is a broad outline of the findings from the course of labor economics. The human capital, defined as the stock of years of education per capita, is highly positively correlated with career earnings. The evolution of human capital across the countries has been a subject of debate on economic growth. The empirical study by Robert Barro and Jong-Wha Lee (link) has shown that, for instance, upper secondary school attendence by males has a significant long-term impact on the economic growth. The level of education, sustained by the years of schooling, is not a sole determinant of economic growth in the international perspective. Although, the economic growth is strongly positively correlated with the average years of schooling, the relationship is less powerful considering different parameters of the educational attainment. In the Barro-Lee dataset (link), there is a significant variation between the share of female population that enrolled in a tertiary education and the share of female that completed the tertiary degree. The difference is significant not only in the cross section but also in the country-based time series.
By far the highest tertiary degree completion rate for females has been present in Australia, Canada, Ireland, New Zealand and the United States. Among other countries, the completion rate of Iceland and the Netherlands has been significantly higher compared to the countries of the Continental and Mediterranean Europe. The rate of return to an additional year of schooling significantly differed across countries and across the level of education. For instance, Barro and Lee estimated that the rate of return is the highest at the tertiary level (17.9 percent per annum) compared to the secondary level (10 percent) while the rate of return from an additional year of schooling at the primary level is statistically insignificant from zero. The picture shows the regional variation in the average rate of return from an additional year of schooling.
Rate of return from an additional year of schooling across the world
Source: R. Barro & J.W Lee: Educational Attainment in the World
, 1950-2010 (link
The creation of human capital is essential to higher economic growth. Ultimately, the investment in human capital is the essential means of higher standard of living in poor countries. An interesting theoretical question is what could account for a divergence across the countries? Considering the relevant economic theory as well as scholarly contributions to the theory and empirics of economic growth, there are several factors that explain the significance of divergence in the rate of return from an additional year of education.
First, the impact of behavioral patterns on education and labor market decisions explains a pretty large part of the difference between the effect of education and labor market structure on the rate of return from schooling. Although the field of behavioral economics (link) is still a largely evolving discipline within the economics, the existing empirical studies of the effects of institutional variables on education outcome try to capture these effects by different proxies such as the estimates of political freedom, the rule of law and civil liberties. The changes in the return to education may be related to these factors since the relative worth of education in regions such as Sub-Saharan Africa and Latin America may incur high opportunity cost given the payoff from predatory behavior or working in the informal sector of the economy.
Second, general and firm-specific human capital investment, the increase in college premium and the enormous increase in female labor force participation help explain high rate of return from an additional year of schooling in advanced countries and East Asia. In particular, East Asian tigers were able to sustain high economic growth rates partly because of well-trained and educated labor force able to use the modern technologies. The resulting outcome of the Asian economic miracles has been a steady growth in output per worker and a gradual convergence of wage rates in South Korea and Japan to the level of U.S. According to Kevin Murphy and Finis Welch (link), the premium of getting a college education in the U.S in 1980s was 67 percent. The growth in college and university attendence rates is largely explained by the robust increase in tertiary education premium.
And third, greater labor force participation of women has also led to higher rates of college and university attendence. In spite the persistent male-female pay gap, women have experienced a tremendous increase in lifetime earnings as a consequence of higher rates of college and university attendence. The persistence of the male-female pay gap can be explained by the rewards to education rather than by inherent gender bias. The U.S. Census published the relevant data (link) on the distribution of female earnings. In 2003, the female earnings of high school graduates in the 25-34 age thresold represented 78 percent of average male earnings. The earnings of the same female age thresold with bachelor’s degree represented 89 percent of male earnings and 71 percent for those female with master’s degree. What accounts for the gender earnings gap across the levels of age and education is the asymmetric self-selection that led to dispersed gender distribution of relative earnings. Men usually self-select into the areas of work requiring a significant amount of risk-taking and rather uncertain payoffs while the female labor market pattern is inclined towards less risk-taking and greater certainty regarding the stability of lifetime earnings.
The data by the U.S. Bureau of Labor Statistics (link) published in 2003, showed that female-to-male earnings ratio in high-paying jobs is the lowest in the field of chief executives where female earnings represented 80 percent of average male earnings in the same field of occupation. On average, the female-to-male earnings ratio declined in low-paying occupations such as cashiers (93 percent), cooks (91 percent), food preparation (93 percent) and hand packaging (101 percent). Contrary to the popular perception, female earnings in the field of computer systems management and legal industry represented 91 percent of average male earnings while the highest ratio in high-paying occupations was recorded in pharmaceutical industry (92 percent).
Indeed, there is a persistent and historically lowest male-female earnings gap. But, as the labor economic theory of human capital predicts, the gender pay difference reflects different cognitive abilities and preferences of occupational selection considering the degree of risk-taking and payoff uncertainty. Even the international test scores (link) confirmed that advantage of female cognitive abilities comprehends in verbal reasoning and reading skills (link) while the cognitive abilities of male are more inclined towards the use of computer technology (link) and mathematics (link).
Even in a cross-country perspective, the gender wage differential persists. The gap, defined as the female-male ratio, ranges from 0.9 in France to 0.7 in Canada. The gender wage differential is a cross section of major economies is shown in the table below.
The Gender Earnings Gap Across Countries
Source: F.D Blau & L.M Kahn, Gender Differences in Pay
The set of different institutional characteristics of labor market in different countries could easily complement the productivity growth rates as to explain the evolution of wage differential across countries. Even though wage rates are primarily determined by the productivity growth, the existence of collective bargaining schemes and rigid labor market mechanism determining wage rate and total compensation can add significantly to the enforcement of particular labor market policies affecting gender bias in wage determination. In the United States and other advanced countries, the main cause of the wider gender earnings gap is a significant gap between college education premium and high school premium. In addition, reductions in personal income tax rates furthermore increase the rewards to college education relative to the education levels of high school or less – which, by the empirical evidence, seems to be the main determinant of earnings gap in the labor market of advanced countries.
Wagner’s law refers to the proposition of Adolph Wagner (1893) that there is a positive relationship between the level of economic development and the size of government. The underlying idea seems to have been that the demand for services provided by government tends to rise strongly as average incomes rise.
I think Wagner’s law still has a huge influence on the thinking of many economists. This influence is evident in the tendency of many economists to view big government as the norm for high-income countries. For example, it explains why economists pose questions like: Why doesn’t the US have a European-style welfare system? This is an odd question because there is considerable variation in the size of welfare states even within Europe and Swedish-style welfare systems are certainly not common among high-income countries outside of Europe.
The influence of Wagner’s law on the modern thinking of economists seems to rest on it being an empirical regularity or stylized fact. If you overlook the wide variation in size of government in high income countries, Wagner’s law does appear to fit some of the facts. Looking back at the recent history of individual OECD countries, most of them clearly had smaller governments 50 years ago when their average incomes were much lower. Yet, a recent study for the UK and Sweden from the beginning of industrialization until the present (a period of 177 years for the UK) found that Wagner’s law does not hold in the long run. The data are inconsistent with Wagner’s law in the initial industrialization phase (prior to 1860) and since the 1970s (Dick Durevall and Magnus Henrekson, ‘The futile quest for a grand explanation of long-run government expenditure’, INF Working Paper 818
The Durevall and Henrekson paper also rejects a rival theory – the ratchet theory – that government spending ratchets up in times of crisis (wars, social upheavals, recessions) and then tends to remain at the new higher level. The expansion of government spending in the 25-35 years following WW2 cannot be explained in terms of a ratchet effect.
Some people might try to rescue Wagner’s law by arguing that it always applies at some stage during the process of industrialization. Thus it might be argued, for example, that Wagner’s law will result eventually in the development of big governments in jurisdictions such as Hong Kong and Singapore that have been able to restrain growth in government, even though they now have relatively high average incomes. However, there do not seem to be any reasons why governments of high income countries would necessarily find it harder than governments of medium to low income countries to resist political pressures to become more heavily involved in activities such as funding of retirement incomes and provision of education and health services. Nor would they necessarily find it harder to resist arguments for the social welfare safety net funded by taxpayers to rise more than proportionately as incomes rise.
If we were desperate to rescue Wagner’s law perhaps we could argue that bigger government is an inevitable response to political pressures associated with the demographic transition – declining birth rates and aging population age structures – associated with economic growth. On this basis Peter Lindert argues that we should expect an expansion of the welfare states in East-Asian countries ‘as they age and prosper’. In OECD countries, including Japan, political systems responded to an increase in the proportion of old people in the populations by providing pensions for aged persons. The further aging of populations has led to increased government spending on pensions – a major factor associated with the growth of government spending in high income countries. Lindert asks: ‘Do we really know that China, Singapore and other East Asians will be more resistant to rising transfer budgets than Japan has been, when they approach Japan’s income level and age structure?’ (‘Growing Public’, Vol 1: 221).
My answer to Peter Lindert’s question is that I don’t know how East Asian governments will respond to an increase in grey power. Perhaps they will see what lessons they can learn from the experience of the big government welfare states of Europe and decide that there is a better way to fund retirement incomes. They might even decide that the compulsory savings approach that has applied in Singapore since 1955 is preferable to the absurdity of taxing people of working age more heavily in order to add unnecessarily to the retirement incomes of their wealthy parents.