A Primer on Stocks and Flows (Part 1)

Harvey Gram
May 18, 2018

The distinction between stocks and flows is essential to economic reasoning. In many cases, it is just common sense. If I tell you that my income is $1000, am I a prince or a pauper? Is it $1000 per hour or $1000 per year? Income is a flow, which must have a time dimension in order to be meaningful. In contrast, if I tell you that my wealth is $1,000,000, you should not be puzzled because wealth is a stock, measured at a point in time. Indeed, if I were to say that my wealth is $1,000,000 per week, you should be puzzled. Is it $1,000,000 at the end of each week; or, on average, $1,000,000 at noon on each day of the week? To keep your stocks and flows in line, always ask of an economic variable: What are its units of measurement and do these units have a time dimension?

A simple case: transporting oil

Imagine closing the valves at each end of an oil pipeline. The oil trapped inside is a stock, measured at a “point in time”. The oil inside all the tankers now at sea is also a stock. The flow of oil through a pipeline occurs over a period of time and depends on the pressure applied to the liquid. In the case of tankers at sea, the delivered flow depends on the number and speed of the ships heading towards some destination. Stocks and flows are intrinsic to transportation problems: goods-in-transit are the stocks; deliveries are the flows over periods of time. Part of the cost of transport is the interest (or other income) that could have been earned on the money, metaphorically “tied up” in the stock—a stock that must be maintained in order for any flow to occur.

Accountants live off the distinction: Income Statements and Balance Sheets

An individual’s Balance Sheet records the values of assets and liabilities. These are stocks, measured at a point in time. The word is used generically, while shares (common and preferred) refer to securities listed on the Stock Exchange. Assets minus liabilities is a residual liability, called net worth, which ensures equality of both sides of the Balance Sheet, a requirement of double entry bookkeeping. Negative net worth simply means that liabilities exceed assets and may signal impending bankruptcy.

On the Income Statement, we find flows of income and expenditure, measured over a period of time, often a year. Income minus expenditure is treated as a residual expenditure, called saving, to ensure equality of both sides of the Income Statement. Positive saving implies a current account surplus. When expenditure exceeds income, saving is negative and the current account is in deficit. A nation’s Current Account Balance just extends this notion of surpluses and deficits for an individual to cover an entire country.

The Balance Sheet and the Income Statement interact. If the flow of income exceeds the flow of expenditure (positive residual saving, or a surplus), then at the end of the period over which the flows are measured, either assets are higher, or liabilities are lower (or both). There is a reverse connection as well. To the extent that assets include common and preferred shares, bonds, and real estate, income will necessarily include corresponding dividends, interest, and rent. Likewise, with liabilities: interest on a loan, for example, counts as an expenditure.

Capital gains and losses complicate the picture. Between two dates, the value of each particular asset or liability can change independently of the income statement. Thus, an individual can have a higher stock of wealth at the end of a period during which expenditure exceeds income (negative residual saving), just so long as capital gains exceed capital losses by a sufficient amount to more than offset the individual’s current account deficit.

The US National Income and Product Accounts (NIPA) and Net International Investment Position (NIIP)

A perennial topic in the financial news concerns an entire nation’s Income Statement, taking account of all households, firms, and governments (federal, state, and local). This accounting of flows appears in the National Income and Product Accounts (NIPA). US expenditure on goods and services exceeded US income in almost every year since 1982. (In 1991, the US received a large transfer from Japan during the first Gulf War prompted by Iraq’s invasion of Kuwait, which had threatened oil shipments.) The largest negative value, -$804.2 billion, occurred in 2006. Negative lending to the rest of the world is the same thing as borrowing from foreign individuals, firms, and governments who, in the process, acquire claims on future US income.

Source: National Income and Product Account, Table 5.1, line 35

Just as an individual cannot spend at a rate that exceeds income without drawing down initial assets or incurring new liabilities, so the US has been either selling its accumulated claims on foreigners or selling new claims on itself to foreigners in recent decades. This occurs on a net basis. US claims on foreigners have actually being going up in every year since 1976, when official data on the US Net International Investment Position (NIIP) was first published. However, foreign claims on the US have being increasing at a faster pace. Such foreign claims take the form of ownership of US money, shares, bonds, land, factories, and buildings. When you read that foreigners own many of the apartments in the most expensive residential areas of New York City, think of this fact as the flip side of US current account deficit in action.

The US NIIP with respect to the rest of the world turned negative in 1989 and has remained so ever since. The most recent entry for 2017 is -$7.845 trillion, an excess of liabilities over assets. This is a stock concept determined by the sum of all past deficits and surpluses from the NIPA flow accounts. Does negative net worth imply impending bankruptcy? Not if our future income (a flow) is sufficient to keep on paying the incomes (e.g. interest and dividends) that foreigners expect to receive on what, for them, are assets.

Source: U.S. Bureau of Economic Analysis, International Data, Table 1.1., line 1

For various reasons, there is not always a tight link between the negative annual US net flow rate of saving and the contemporaneous change in the US NIIP. One problem is the difficulty of accurately measuring international trade in services, not to mention private transfers (which may involve illegal transactions). Another is the problem of accounting for capital gains and losses. The US enjoys the ability to borrow in its own currency, i.e. most claims on the US are denominated in US dollars and so, from the US point of view, are unaffected by changes in exchange rates. However, many US claims on foreigners are denominated in foreign currencies, which, in some years, appreciate; thereby increasing the US dollar value of US owned foreign currency denominated claims. Appreciation of the US dollar has the opposite effect. Part of the fluctuation in the US NIIP occurs because of such changes in exchange rates.

Between the individual and the nation as a whole, there are many sub-aggregates. The flow accounts for the consolidated (federal, state, and local) government sector attract attention from politicians and the press when fiscal policy changes are under discussion. Government net lending equals tax receipts minus transfer payments and expenditure on goods and services. As shown below, such lending has been positive in just three years since 1982, corresponding to increasing government surpluses from 1998 to 2000. Economists began to wonder what would happen if the associated retirement of government debt—this is what happens when the government is a net lender—were to continue long enough to leave the financial system without any US Treasuries to hold as a safe asset against which to rank other assets. It turned out to be an “academic” question. Net lending by all branches of government turned negative in 2001, reached a peak of -$1.566 trillion in 2010, and then moved back towards zero. Government borrowing (the negative of net lending) was -$843 billion in 2017.

Source: U.S. Bureau of Economic Analysis, NIPA Table 3.1, line 31

The National Income Accounting Identity keeps track of the relationship between the income and expenditure flows of three sectors: private, public, and foreign. If any sector is a net borrower, at least one other must be a net lender, as it is not possible for all to borrow or to lend. The “foreign sector” is the flip side of our current account balance, defined as exports minus imports plus net foreign income (which can be negative) minus US private and public transfers to the rest of the world. If the current account is negative, then the foreign sector has a surplus and so either the private sector or the public sector must have a deficit. This does not imply causation, but provides a coherent framework for discussion. Any policy change (such as tariffs on imports) intended to reduce the nation’s current account deficit will certainly fail unless that policy also increases either the private sector surplus or the government sector surplus (currently negative so that an increase means a smaller negative number).

Of the three sectoral balances, the government’s is the easiest to understand—tax receipts net of transfers (T) minus expenditure on goods and services (G), largely produced by the private sector (G also includes the salaries of government employees and military pay). The foreign sectoral balance is tricky only because it is the nation’s current account balance with the sign reversed. If the US has a current account deficit, then the foreign sector (the rest of the world) has a surplus with the US. The private sector balance requires more thought because of the definitions of “Saving” and “Investment” in the NIPA. Saving is defined as total private after-tax income from all sources (this year’s wages and salaries, rent, interest, and gross profit) minus consumption, which is household expenditure on currently produced durable and non-durable goods and services, except for residential structures. Investment in the NIPA is defined as residential and non-residential fixed investment plus the net change in business inventories. Non-residential (business) investment has three parts: structures (e.g. new factory buildings), equipment, and intellectual property products (e.g. new business software). Accordingly, if private sector saving (S), largely accounted for by the gross retained earnings of the business sector, exceeds investment (I), then the private sector runs a surplus and must be a net lender. Otherwise, it is a net borrower.

Four years of data for the US show various cases of lending and borrowing (in billions of current dollars). In 1965, a private surplus financed a government deficit and a foreign deficit (US current account surplus). In 2000, a private deficit was financed by a government surplus and a foreign surplus (US current account deficit). In 2006, a private deficit and a government deficit were financed by a foreign surplus. In 2016, a private surplus and a foreign surplus financed a government deficit. Note that the current account deficit (foreign surplus) and the government deficit are not necessarily “twins”, as is often suggested. Sometimes they move together, but not always, because the private sector surplus can also change. (In the table, the NIPA Statistical Error is subtracted from the Current Account to obtain, with sign reversed, an “Adjusted Foreign Surplus”. Government Investment in the NIPA is added to G and government depreciation allowances are added to T. These alterations ensure zero column sums for each year, to satisfy the National Income Accounting Identity.)

  1965 2000 2006 2016

Private Surplus: S – I 28.3 – 358 – 137 634
Government Surplus: T – G – 22.9 54 – 448 – 948
Adjusted Foreign Surplus – 5.4 304 585 314

 

A Primer on Stocks and Flows (Part 1)2018-07-04T19:37:45+00:00

May 04: Total Employment Increased by 164,000 in April, and the Unemployment Rate Edged Down to 3.9 Percent

Total nonfarm payroll employment increased by 164,000 in April, and the unemployment rate edged down to 3.9 percent, the U.S. Bureau of Labor Statistics reported today. Job gains occurred in professional and business services, manufacturing, health care, and mining. Read more

May 04: Total Employment Increased by 164,000 in April, and the Unemployment Rate Edged Down to 3.9 Percent2018-05-04T13:08:36+00:00

A Primer on Exchange Traded Funds: Costs and Benefits

Ernesto Garcia
April 30, 2018

Exchanged Traded Funds (ETFs) have been around since 1989. By the end of 2017, global ETF assets totaled $4.569 trillion. The main reason ETFs have become so popular is straightforward—an individual investor can own, through the ETF, a basket of assets that would otherwise be very expensive to replicate in the open market. Moreover, the assets in an ETF reflect the fund’s investment strategy, which usually does not change over the life of the fund. Individuals can effectively adopt the fund’s strategy, knowing it will not suddenly change in a way that no longer reflects his or her preferences concerning risk and return, sectoral and geographic balance, etc. ETFs are like mutual funds in this respect. In both cases, investors are considered passive—they are not actively buying and selling shares of stocks.

What separates ETFs from mutual funds is that, as the name suggests, ETFs are traded on exchanges like any other stock while mutual funds require membership in the institution that owns the fund. Another advantage is that ETFs require only a one-share investment while mutual funds restrict an investors’ minimum investment (almost always much higher than a single share of an ETF). Finally, and perhaps most importantly, mutual funds are only traded after the market closes, and this trade is done directly with the fund itself. ETFs are traded all day like any other stock. Thus, a mutual fund investor wanting to react quickly to intraday news, financial or otherwise, cannot do so. This can only be done at the end of the trading day while an ETF investor can buy or sell shares throughout the day.

How do ETFs Work?

ETFs are traded on exchanges just like individual equities and have similar attributes. Like stocks, they have a quoted price and a certain number of outstanding shares. Multiplying the price by the number of shares yields the market capitalization (market cap) of the ETF. Unlike the stock of a company, however, this market cap does not tell the full story of the value of an ETF’s shares. To understand why it is helpful to know how such shares are created.

Consider the SPDR (Standard and Poor Depository Receipts) S&P (Standard & Poor) 500 ETF Trust, known by its ticker symbol SPY. Owned and operated by S&P Global, it is the largest ETF in the world with an investment strategy that attempts to mirror movements in the S&P 500 index. If the S&P 500 index weights the stock of Apple at 3% of its value, then Apple will make up 3% of the basket of assets the SPY fund holds and similarly for all 500 components of the S&P.

However, ETFs do not purchase shares of stock (or other assets) directly in the open market. Rather, the ETF creates and redeems shares using an entity called an Authorized Participant (AP). Like a market maker, APs can buy and sell very large volumes of assets. The AP buys shares of the underlying assets on the open market and then the AP will trade this portfolio of underlying assets for shares of the ETF which the AP can then sell on the open market. In our example, S&P Global creates SPY shares while one or more APs purchase shares of companies included in the S&P 500 index. The AP will then exchange this portfolio of shares in the S&P 500 index for SPY shares in a process called creation. The opposite of creation is redemption. Redemption occurs when the AP purchases SPY shares in the open market and then exchanges these for a portfolio of shares corresponding to the S&P 500 index. These shares can then be sold by the AP in the open market and the redeemed ETF shares are retired. The AP chooses when they want to create or redeem shares of the ETF. This process of redemption and creation is what allows the ETF to be traded like ordinary shares of stock.

The price of ETF shares fluctuates during the trading day, just like any other ordinary share of stock, altering the market cap of the ETF. However, this is not necessarily the value of its underlying assets, or Assets Under Management (AUM), which also fluctuates during the trading day (since the underlying assets are individually traded on the open market). Such variation opens the possibility for profitable arbitrage, subject to transactions costs. Typically, APs are the largest potential arbitragers. Thus, if the market cap of the ETF falls below the corresponding AUM, a trader can buy low and sell high, purchasing ETF shares and simultaneously selling the corresponding AUM portfolio for a net gain. Few individual investors will act this way—they are, after all, typically passive investors. However, there is a segment of active investors in ETF funds constantly on the lookout for opportunities to buy low and sell high. This can be a good thing for the passive investors who count on the fact that the value of their ETF shares accurately reflects the value of the underlying shares they indirectly own.

Advantages of ETFs

The biggest advantage of an ETF for the typical retail investor is the low transaction costs associated with owning them. Fees paid for ETFs are generally much lower than those for mutual funds. Trading is also less costly since one pays the same amount to purchase a share of an ETF as it would cost to purchase the share of any company’s stock. Another advantage is that the minimum investment required is the price of one share of the ETF. This allows a retail investor to get the advantages of diversification at a price far lower than what it would cost to purchase the actual portfolio of underlying shares or the minimum investment required for a mutual fund. ETFs are traded throughout the day so retail investors can make investment decisions whenever the market is open rather than just at the end of the day as with mutual funds. Such trading allows arbitragers to keep the price of an ETF share close to the value of the underlying assets (AUM). Investors can also sell short or buy on margin.

Drawbacks of ETFs

While ETFs are intended to be passive investment instruments, the existence of active trading can be a source of instability. To highlight this, consider the following scenario. Currently, Apple shares constitute 4% of a SPY share. Suppose Apple reports unexpectedly low earnings causing the stock to sell off. The S&P 500 index only rebalances once every quarter, so even though Apple’s stock has fallen in price, Apple still maintains a 4% weight in the index and hence 4% of the SPY. Then, because the fall in the price of Apple’s stock lowers the value of the SPY’s underlying assets, it can cause SPY shares to be overvalued relative to the S&P 500 it is tracking. The AP, which holds a large number of shares of the SPY, will start selling the overvalued shares. A resulting price decline may cause other holders (such as retail investors) to start selling as well. If the price of SPY were to fall below its underlying asset, the AP will reverse direction, redeeming SPY shares from the fund for shares of the underlying stocks, and selling them on the open market. This, in turn, puts downward pressure on the price of those shares and so a cycle can develop even though SPY, like all ETFs, is meant to be a passive investment vehicle.

In our example, selling pressure on Apple’s stock has spread throughout the market via the seemingly passive ETF. Passive ETF investors usually ignore intraday fluctuations since they are long-term investors. However, ETFs allow for active trading and the process of creation and redemption together with active trading can lead to market contagion from a single stock’s price action. Since ETFs are such a large asset class now, this drawback cannot be ignored. Our Apple stock scenario could become more widespread especially as more investors purchase ETFs not knowing what the underlying assets are. Another concern that one must think about is events where market liquidity dries up. We assume arbitragers and the AP can simply buy and sell shares of the underlying ETF. But what if they cannot do it without causing a massive move in price?

An example of this occurred with the recent sell-off in the Daily Inverse VIX Short-Term ETN (Exchange Traded Note). ETNs are a type of unsecured, unsubordinated debt security and trade on exchanges just as ETFs do. The big similarity worth highlighting between the two is how retail investors easily trade them without much knowledge about trading debt. The VIX index (a popular measure of the stock market’s expectation of volatility implied by S&P 500 index options) increased by a large amount on February 5 of this year and caused the Daily Inverse VIX Short-Term ETN to drop over 80%. Not only did long-term investors in this ETN experience heavy loses, but there also appeared to be an associated overall market sell-off during the following week. While this was a leveraged ETN, it was very small compared to many of the other ETNs and ETFs in the market right now. What would happen if Apple experiences a major sell-off? These are questions that need to be raised and discussed as investor flows into ETFs continues to rise in the future.

A Primer on Exchange Traded Funds: Costs and Benefits2018-07-04T19:37:46+00:00

April 24: New York State Department of Labor Reported That Employment Statewide Was Flat in March

The New York State Department of Labor reported a gain of only 500 jobs statewide in March, following a gain of almost 30,000 in February.  Employment in the state is up 1.1% over a year-ago compared to 1.5% for the nation. The Bureau of Labor Statistics reported that New York City lost 2,600 jobs in March following a gain of about 22,000 in February.  Employment in the city is up 1.8% over a year ago. Read more

April 24: New York State Department of Labor Reported That Employment Statewide Was Flat in March2018-04-25T03:02:19+00:00

U.S. Tax Reform: Where Are We Now?

Rubaiyat Tasnim and the ESG
April 12, 2018

On February 28, 2018, the Graduate Center Public Programs and the Stone Center on Socio-Economic Inequality held a panel on tax reform where experts discussed its implications and how it will impact different constituencies. Panelists were: Larry Kotlikoff, the William Fairfield Warren Professor and Economics Professor at Boston University; Lily Batchelder, the Frederick and Grace Stokes Professor of Law at NYU School of Law and Professor at the NYU’s Wagner School; Leonard Burman, co-founder of the Urban-Brookings Tax Policy Center, the Paul Volcker Professor and Professor of Public Administration and International Affairs at the Maxwell School, and a Senior Research Associate at the Syracuse University; and the Nobel Laureate Paul Krugman, a Distinguished Professor of Economics at the Graduate Center and New York Times columnist. The discussion was moderated by Kathleen Hays, global economics and policy editor at Bloomberg.

Statements by Panelists on the Tax Bill

Paul Krugman started off the discussion by questioning why we are cutting taxes at this point in the business cycle. The US economy is at full employment and the government is in deficit. As the US population is growing older, the burden of maintaining programs such as Medicaid, Medicare, and Social Security is growing as well. The tax cut is only worsening our fiscal condition.

Leonard Burman stated that the tax system needs to be reformed and pointed out the problems of the current system including its inefficiency, complexity, unfairness, and inability to raise enough revenue for the government. The Congressional Budget Office has projected 10 trillion dollars in deficits over the next decade. The US corporate tax rate is high compared to other nations, but the tax bill cut the tax rate for unincorporated business as well which is not very high relative to other countries. The bill succeeded in giving the Republican Party a legislative victory which not only helped them undermine the Affordable Care Act but might also behave the way Reagan’s 1981 tax cut did – it may distort the tax code much more to generate momentum for another tax reform in five years.

Lily Batchelder started her introduction by stating that she has been a fan of tax reform but it is setting out to do the exact opposite of what she was expecting. The tax reform should have addressed the long-term fiscal issues through generating more revenue. The bill is very heavily tilted towards tax cuts for the wealthy. As it is increasing the deficit, it is putting social programs in danger in the future. She highlighted the biggest new loophole in the code: The new pass through deduction cuts taxes for unincorporated businesses and greatly complicates the administration of the tax code to try to ensure that individuals do not form an unincorporated business to avoid the higher individual tax rate.

Laurence Kotlikoff agreed with other panelists about the current condition of US economy, and noted that enormous amounts of off the book debt and contingent liabilities, which when properly accounted for, makes it a 200 trillion dollar debt rather than a 20 trillion dollar debt. He believes the tax reform has positive elements and that there will be a significant increase in capital formation in the country, a 15% increase over time and a 5 and half percent increase in wages, which would offset the increase in debt to GDP ratio. The unfunded liabilities grow by about 6 trillion dollars per year, which compared to the increase in debt of about 1.6 trillion dollars in 10 years is much more substantial. He argued that the tax reform did not increase inequality. As the share of spending of the top 1% within each group will not change at all, he states that the tax reform is fair. The absolute amount of tax benefits for richer will be higher as they pay higher taxes.

Supply side: Will the companies invest more and create more jobs?

L. Kotlikoff argued that as the marginal corporate tax is lowered from 34.6% to 18.8%, a lot of capital from abroad will come in and will be staying in the US. This will impact wages by increasing them by 5.5% over the next ten years. The consumption rate is extremely high, with national saving rate at only 4%, and with a domestic investment rate of 5%, only 1% of national income is being invested from abroad into US. As the country saves too little, the reform will help move capital from abroad.

P. Krugman agreed with L. Kotlikoff that it will attract capital from abroad, but believes it will take a long time. If the bill works, it will still nonetheless produce huge trade deficits for a decade or more. This trade deficit will lead to strong dollars which will deter investments. The corporate profits in US are a return to monopoly power. As taxes are cut on monopolies and new investments are not generated, this will increase wages. As more capital moves from all over the world to the US, it will raise the return on capital all over the world. With more capital from abroad being invested, the returns paid to them will increase and the net benefit to the residents will be only the tax wedge. Foreigners already own a third of equity in US and this tax reform cuts taxes on that. Keeping all these factors in mind, this tax reform will fail to increase income and it will only exacerbate the deficit problem.

L. Batchelder pointed out how there could have been a way to do business tax reform that could help the economy in the long run. This bill loses a huge amount of revenue and may not have been a good time to act on an economic stimulus. The positive growth effects of the tax reform disappear and potentially reverse. Raising taxes in the future or cutting spending programs may be necessary to pay for the tax reform and will likely put a drag on growth.

L. Burman added to these points by stating how the models developed by the Joint Committee on Taxation do not produce the big macro effects advocated by the supporters of the tax reform. The bill allows firms to immediately deduct the cost of new investments, called expensing. Theoretically, this will encourage them to invest more, make workers more productive and could raise wages. Empirically, there has not been a huge response to tax reforms in many countries or even within the United States. The tax rate cut to foreign holders of US equities will only benefit the foreign equity holders. He gave the example of 1986 corporate tax rate cut which led to other US trading partners to cut their tax rates in response, eventually reducing the effectiveness of tax rate cuts.

What Is the Tax Reform’s Impact on the Economy and Will It Benefit All?

P. Krugman stated that the tax reform will lead to more spending. But it would have been better to have done that when the unemployment rate was 9.5% rather than now. The fast economic growth will also see a hike in interest rates by Jay Powell, the new chairman of the Federal Reserve, which will limit the effect of the tax reform. So, the increase in consumer confidence will not initiate much growth. The deficit spending in a full employment economy will react differently than deficit spending in a depressed economy. Orders for new capital equipment, which is the first early indicator of an investment surge has not gone up yet.

L. Burman, addressing the stock market rise, stressed the point that the increase in profitability is from the companies making decisions assuming a tax rate of 35%. The value of the profitable companies go up when the income is taxed at 21%, which is a one-time shift and unlikely to continue. The observation that a lot of the companies are paying bonuses and wages are going up are not anomalies at this stage of economic cycle. As the labor market is getting tighter, the companies are competing to keep their workers through bonuses.

L. Batchelder distinguished between the direct and indirect effects of tax bill. She terms this bill as an “incredibly regressive bill” when considering the direct effects on employee compensation or wages. As an example, the average tax cut for a household with $40-50,000 is about $400, while a household with a million dollars’ income gets a tax cut of $27,000. Adding on the indirect effects, as calculated by JCT, 25% of all corporate tax cuts benefits labor. Incorporating all these effects, the tax cuts for the wealthy is three times larger than they are for the middle class. As the individual provisions expire, every income group earning less than $75,000 on average loses out.

L. Kotlikoff disagreed arguing that the tax reform is not regressive. He explained that the same tax rate cut for rich means a bigger absolute tax break, as they earn more to begin with. Looking at the inequality in spending, the share of spending in the top 1% in any age-cohort remain unchanged and so does the share of taxes they pay. He terms the tax reform as a “second-rate reform,” because it failed to raise revenue and will undermine public education and Obama Care, leading to another 10 million people being uninsured. He emphasizes comparing people within their age group when comparing taxes paid.

P. Krugman focused on the lost revenue that has to be offset by spending less on social programs. So, the effects on the after-tax-and-transfer distribution of income makes the tax reform regressive, impoverishing the government even further.

L. Kotlikoff stated that despite some simplifications in the tax code, the pass-through still remains complicated.

Batchelder stated that the pass through deduction opens up huge gaming opportunities. She added that the pass-through deduction is providing the largest benefits to the wealthy, with the top 1% earning 50% of the pass-through business income. A pass-through business refers to certain ways to organize a business in which profits are immediately passed through to owners and are subject to the individual-level tax but not a corporate –level tax. These business forms include sole proprietorships, partnerships, and S-corporations. The pass-though deduction allows these businesses to write off 20% of business income to try to make up for the higher individual tax rate that pass-throughs are subject to but also limits the deduction. The limitations are complex and this creates more complication than simplification.

U.S. Tax Reform: Where Are We Now?2018-07-04T19:37:46+00:00

New York City Job Growth: Healthy, but Divergent Across Sectors

James Orr
March 27, 2018

Recently-released employment data show job growth in New York City in 2017 was down only mildly from its pace in 2016 and is still above the comparable nationwide rate. On an average annual basis, employment in New York City expanded 2.0 percent in 2017 following a gain of 2.1 percent in 2016; these city growth rates, however, fall short of the 3.0 percent job growth rate in the city in 2015. For the state as a whole, job growth rates in each of the past two years were below those of the city and also slightly below the national rate, a pattern that has held for much of the roughly eight year period since the recovery of employment in New York got underway. This post examines these state and city employment trends and highlights the recent job performance in key sectors making up the New York City economy.

Employment Trends in New York City and New York State

The recovery of employment in New York City from the downturn and financial crisis began in late 2009 and has been quite strong compared to the nation. The figure below, also presented here, shows the robust recovery of employment in the city relative to both the nation and the state in this recovery. Job growth in the city had shown some weakness in late summer 2017, as discussed in an earlier post, but subsequent gains helped the city achieve healthy growth, 2.0 percent, for the year as a whole. In terms of job counts, the city added about 85,000 jobs in 2017 compared to just under 90,000 in 2016. The figure also indicates a declining rate of job growth in the past two years relative to the strong gains seen in 2014 and 2015 which roughly matched or exceeded 3.0 percent. In 2015, for instance, the city added 123,000 jobs. A measure of economic activity in the city also shows a pattern of strong though gradually slowing growth over the past several years.

Statewide, the recovery of employment has generally not been as strong as in the city. In 2017 job growth in the state was 1.3 percent, slightly below its 2016 pace and below both the city’s growth and the 1.6 percent job growth in the nation. As has been discussed previously, this disparity in growth across areas in New York State has persisted for some time and reflects the relatively slower pace of employment growth in the metropolitan areas in upstate and western New York. The more rapid job growth in downstate areas was again seen in 2017, though it should be noted that growth continued at a relatively strong pace in the Albany area and, after slipping for much of 2016, growth picked up in the Buffalo area.

Performance of Key Sectors in New York City

The relatively healthy overall job growth in New York City in 2017 reflects the net effects of growth in the diverse sectors that make up the city’s economy. The figure below shows the annual average job growth rates in 2016 and 2017 in the sectors making major positive contributions to growth.

Among the sectors, annual average job growth in 2017 was strongest in three of the city’s largest services sectors—education and health, professional and business services, and leisure and hospitality. Nationwide, these sectors also were high performers in 2017, with annual growth rates for each at 2.0 percent or more. The education and health sector in the city increased its growth rate over 2016 led by continued strong expansion of jobs in the health component. Growth rates in both the professional and business services and leisure and hospitality sectors in the city, however, were slightly off their 2016 rates.

Job growth was also high in the construction sector which reflects, in part, the continued high growth of residential building permits in the city. While strong, growth in the sector was off its 5.6 percent pace in 2016.

The information and transportation and warehousing sectors made relatively strong contributions to job growth in 2017 and both sectors expanded moderately faster than in 2016. Developments in the transportation and warehousing sector has been linked to the evolution of shopping trends, specifically, the decline in employment in traditional department stores and the corresponding rise of online shopping. The increasing demand for storage and delivery of items bought online likely is related to the changing nature of consumer shopping, a nationwide trend that is playing out in New York City.

Employment in the city’s financial activities sector, which includes the securities sector (Wall Street), banks, insurance companies and real estate firms, expanded by 0.8 percent in 2017, down from its gain of 1.4 percent in 2016. Jobs in the securities component were essentially flat in 2017 after rising by about 4,000 in 2016. Jobs here account for a little less than 5.0 percent of city private sector jobs but it has an outsized role in the city’s economy as the sector accounts for a little over 20 percent of private sector earnings. These high earnings gives the sector an important role in supporting demand and in city and state tax revenues.

The figure below shows annual average job growth rates in 2016 and 2017 in the sectors with weaker or negative contributions to job growth.

The retail trade sector in the city had modest job gains in 2017 following losses in 2016 and, as noted above, growth in the sector has been constrained to some extent in recent years by the shift of consumers to online shopping. In fact, the level of overall retail employment in the city has been fluctuating around 350,000 each year since 2014. Job growth in the government sector was flat in 2017 following a slight gain in 2016, mirroring national trends. Local government employment is the largest component of the sector in the city and current employment totals there remain roughly at the level they reached just prior to the downturn in the city’s economy.

Wholesale trade employment in the city saw modest declines in 2017 following an essentially flat performance in 2016. Jobs in the wholesale trade sector, as with retail trade, have been not expanding in line with the city’s generally robust job performance and the level of employment has been fluctuating around 145,000 since 2014.

The city’s manufacturing sector had a significant decline in jobs in 2017, losing 3.9 percent of employment, following a decline of 2.2 percent in 2016. As in the nation, this sector in the city has been experiencing secular declines in employment and job counts are down by about 20,000, or roughly 26.0 percent, over the past ten years.

Looking Ahead

The recent employment picture in the New York City economy is one of fairly healthy growth though the pace has slowed from the relatively high rates of previous years. Two reports project that this gradual slowing in the rate of overall city job growth will continue over the next several years. It is likely that the three major services sectors in the city that have been key drivers of job growth–education and health, professional and business services and leisure and hospitality—will continue to be sources of new jobs going forward. Some offset to these gains could come from further declines in the city’s retail trade and manufacturing sectors.

One factor that can be expected to influence the city’s job growth is the performance of the national economy. Projections have economic growth picking up a bit in 2018 over its 2017 pace but then slowing modestly through 2020. A risk to the outlook is that the national economy expands less than expected and thus weighs down city employment growth. Another risk arises from the provision in the recently-passed Tax Cuts and Jobs Act of 2017 which limits the size of the individual federal deduction for state and local tax payments. It remains to be seen what the consequences of this legislation will be for the state and city economies.

New York City Job Growth: Healthy, but Divergent Across Sectors2018-07-04T19:37:46+00:00

March 21: Federal Reserve to Raise Fed Funds Target Range to 1.50 to 1.75 Percent

In view of realized and expected labor market conditions and inflation, the Federal Reserve FMOC decided to raise the target range for the federal funds rate to 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. Read more

March 21: Federal Reserve to Raise Fed Funds Target Range to 1.50 to 1.75 Percent2018-03-21T20:52:23+00:00

March 09: Total Non-Farm Payroll Employment Increased by 313,000 in February

Total non-farm payroll employment increased by 313,000 in February, and the unemployment rate was unchanged at 4.1 percent, the U.S. Bureau of Labor Statistics reported today. Employment rose in construction, retail trade, professional and business services, manufacturing, financial activities, and mining. Read more

March 09: Total Non-Farm Payroll Employment Increased by 313,000 in February2018-03-12T00:16:56+00:00

The Welfare State in the Age of Globalization

Branko Milanovic
March 05, 2018

It has become a truism to say that the welfare state is under stress from the effects of globalization and migration and thus may not be able to provide the same level of income support that it had provided in the past. In my previous post that looked at policies to reduce inequality in the 21st century, I mentioned that I would follow up with a discussion of the welfare state. In this post I want to go back to the origins of the welfare state to understand the origin of the current stress.

As Avner Offer has recently reminded us in his excellent book (co-authored with Daniel Söderberg), the origin of social democracy and the welfare state is in the realization (and financial ability to deal with it) that all people in their lives go through periods where they are not earning anything, but have to consume: this applies to the young (hence children’s benefits), to the sick (health care and sick pay), to those who had a misfortune to get injured at work (worker’s accident insurance), to mothers when they give birth (parental leave), to people who lose jobs (unemployment benefits), and to the elderly (pensions). The welfare state was created to provide these benefits, delivered in the form of insurance, for either unavoidable or very common conditions. It was built on the assumed commonality of behavior or, differently put, cultural and often ethnic homogeneity. It is no accident that the prototypical welfare state born in Sweden in the 1930s, had many elements of (not used here in a pejorative sense) national socialism.

In addition to commonality of behavior and experiences, the welfare state, in order to be sustainable, required mass participation. Social insurance cannot work on small parts of the workforce because it then naturally leads to adverse selection, a point well illustrated by the endless wrangles over US health care. The rich, or those who are unlikely to be unemployed, or the healthy ones, do not want to subsidize the “others” and opt out. The system that would rely only on the “others” is unsustainable because of huge premiums it would require. Thus the welfare state can work only when it covers all, or almost all, of the labor force, i.e. when it is (1) massive and (2) includes people with similar conditions.

Globalization erodes both requirements. Trade globalization has led to the well-documented decline in the share of the middle class in most western countries and the polarization of income. With income polarization the rich realize that they are better off creating their own private systems because sharing the systems with those who are substantially poorer implies sizeable income transfers. This leads to “social separatism” of the rich, reflected in the growing importance of private health plans, private pensions, and private education. The bottom line is that a very unequal, or polarized, society cannot maintain an extensive welfare state.

Economic migration, to which most of the rich societies have been newly exposed in the past fifty years (especially so in Europe), also undercuts the support for the welfare state. This happens through the inclusion of people with actual or perceived differences in social norms or lifecycle experiences. It is the same phenomenon as dubbed by Peter Lindert as a lack of “affinity” between the white majority and African Americans in the US which rendered the US welfare state historically smaller than its European counterparts. The same process is now taking place in Europe where large pockets of immigrants have not been assimilated and where the native population believes that the migrants are getting an unfair share of the benefits. Lack of affinity need not be construed as some sinister discrimination. Sometimes it could be indeed that, but more often it may be grounded in correct thinking that one is unlikely to experience the lifecycle events of the same nature or frequency as the others, and is hence unwilling to contribute to such an insurance. In the US, the underlying fact that African Americans are more likely to be unemployed probably led to less generous unemployment benefits; similarly, the underlying fact that migrants are likely to have more children than the natives might lead to the curtailment of children’s benefits. In any case, the difference in expected lifetime experiences undermines the homogeneity necessary for a sustainable welfare state.

In addition, in the era of globalization more developed welfare states might experience a perverse effect of attracting less skilled or less ambitious migrants. Under “everything being the same” conditions, a decision of a migrant where to emigrate will depend on the expected income in one country vs. another. In principle, that would favor richer countries. But we have also to include a migrant’s expectation regarding where in the income distribution of the recipient country she expects to end up. If she expects to be in the low income deciles, then a more egalitarian country with a larger welfare state will be more attractive. An opposite calculation will be made by the migrants who expect to end up in the higher deciles of the recipient countries’ income distributions. If the former migrants are either less skilled or less ambitious than the latter, then the less skilled will tend to choose countries with more developed welfare states. Hence the adverse selection.

In very abstract terms, the countries that would be exposed to the sharpest adverse selection will be those with large welfare states and low income mobility. Migrants going to such countries cannot expect, even in the next generation, to have children who would climb up the income ladder. In a destructive feedback, such countries will attract the least skilled or the least ambitious migrants and, once they create an underclass, the upward mobility of their children will be limited. The system then works like a self-fulfilling prophecy: it attracts ever more unskilled migrants who fail to assimilate. The natives tend to see migrants as generally lacking in skills and ambition (which may be true because these are the kinds of people their country attracts) and hence as “different”. At the same time, failure to be accepted will be seen by the migrants as confirmation of natives’ anti-migrant prejudices, or, even worse, as religious or ethnic discrimination.

There is no easy solution to the vicious circle faced by developed welfare states in the era of globalization. This is why I argued in my previous blog for (1) policies that would lead toward equalization of endowments so that eventually taxation of current income can be reduced and the size of the welfare state be brought down, and (2) that the nature of migration be changed so that it be much more akin to temporary labor without automatic access to citizenship and the entire gamut of welfare benefits. This last point is discussed in Chapter 3 of my “Global inequality” as well as here.

The original post can be found at GlobalInequality.

The Welfare State in the Age of Globalization2018-07-04T19:37:46+00:00
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