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Solution Manual for Economics of Macro Issues, 8th Edition

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    Online Solution Manual By Ninos P. Malek San Jose State University & De Anza College For The Economics of Macro Issues Eighth Edition Roger LeRoy Miller Research Professor of Economics University of Texas, Arlington Daniel K. Benjamin Clemson University, South Carolina and PERC, Bozeman, Montana

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    Table of Contents Chapter 1: Rich Nation, Poor Nation ....................................................................................................... 1-1 Chapter 2: Innovation and Growth ........................................................................................................... 2-1 Chapter 3: Outsourcing and Economic Growth ....................................................................................... 3-1 Chapter 4: Poverty, Capitalism, and Growth ........................................................................................... 4-1 Chapter 5: The Threat to Growth ............................................................................................................. 5-1 Chapter 6: Hello Boomers, Goodbye Prosperity ...................................................................................... 6-1 Chapter 7: What Should GDP Include? ................................................................................................... 7-1 Chapter 8: What’s in a Word? Plenty, When It’s the “R” Word .............................................................. 8-1 Chapter 9: The Disappearing Middle Class ............................................................................................. 9-1 Chapter 10: Capital, Wealth, and Inequality .......................................................................................... 10-1 Chapter 11: The Great Stagnation .......................................................................................................... 11-1 Chapter 12: The Case of the Missing Workers ...................................................................................... 12-1 Chapter 13: The Gig Economy .............................................................................................................. 13-1 Chapter 14: Mobility in America ........................................................................................................... 14-1 Chapter 15: Inflation and the Debt Bomb .............................................................................................. 15-1 Chapter 16: Is It Real, Or Is It Nominal? ............................................................................................... 16-1 Chapter 17: Can We Afford the Affordable Care Act? .......................................................................... 17-1 Chapter 18: Who Really Pays Taxes? .................................................................................................... 18-1 Chapter 19: Are You Stimulated Yet? ................................................................................................... 19-1 Chapter 20: Higher Taxes Are in Your Future ....................................................................................... 20-1 Chapter 21: The Myths of Social Security ............................................................................................. 21-1 Chapter 22: The Fed and Financial Panics ............................................................................................. 22-1 Chapter 23: The Fed Feeding Frenzy ..................................................................................................... 23-1 Chapter 24: Deposit Insurance and Financial Markets .......................................................................... 24-1 Chapter 25: Revolutionizing the Way We Pay ...................................................................................... 25-1 Chapter 26: Cryptocurrencies................................................................................................................. 26-1 Chapter 27: The Value of the Dollar ...................................................................................................... 27-1 Chapter 28: The Eurozone after Brexit .................................................................................................. 28-1 Chapter 29: The Global Power of the Big Mac ...................................................................................... 29-1 Chapter 30: The Opposition to Globalization ........................................................................................ 30-1 Chapter 31: The $750,000 Job ............................................................................................................... 31-1

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    1-1 Chapter 1 Rich Nation, Poor Nation „ Chapter Overview Perhaps the most important determinants of a country’s economic growth are the laws and institutions under which its citizens operate. Stable laws and mechanisms to protect citizens from the government and each other are necessary for economic growth to be significant and lasting. The rationale behind this is simple: individuals will not choose to invest if they do not have a reasonable expectation of reaping the rewards of their investment. This investment, in both physical and human capital, is required for prolonged economic growth. „ Descriptive Analysis Economic growth requires institutions that protect investment and its proceeds. Two major types of legal systems are outlined in this chapter: common law and civil law. Common law legal systems grant judges the authority to decide the law when there is no other authoritative statement of the law. These decisions are binding for all other cases that are similar until there is another authoritative statement of the law by a legislature or higher court. This statement of the law announces the “rules of the game” and enables economic participants to make investment decisions under relative certainty. Unlike the English-based common law system, civil law has its roots in Roman law. Civil law legal systems draw on abstract rules that judges must apply to cases before them. Rather than relying on judicial precedents, judges in civil law nations base their judgments on the provisions of codes and statutes or the general principles of these codes. This tends to generate incentives for governing bodies in these countries to pass statutes that deal with specific situations and can lead to preferential treatment of special interests. Besides mixtures of common and civil law systems, two general other legal systems exist in the world: the Islam Fiqh system and legal systems based upon custom. The importance of the legal system to economic growth is tied to the protection of property rights. Citizens under the common law system, who can turn to precedents where courts have protected property rights, are more likely to make long-term investments that can lead to increased human and physical capital. Civil law nations, where property rights are more easily overturned through new codes, generate a less secure investment environment and hence generate lower amounts of capital. One study by Mahoney argues that between 1960 and the 1990s, growth was one-third higher in common law nations relative to civil law nations. The type of legal institution developed within a nation has much to do with its history. English colonies tended to adopt the common law system. However, other factors have influenced the development of institutions. Tropical colonies tended to be affected by disease more than temperate colonies. As disease

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    Miller, The Economics of Macro Issues , 8 th Edition 1-2 shortened life expectancy, colonists were more interested in extracting resources rather than establishing permanent institutions that would lead to long-term growth. Lacking these institutions historically may explain one reason why growth is much higher in temperate areas of the world. „ Teaching Tips Often students have trouble seeing the importance of institutions, especially if they have not traveled to other countries. To make this easier, start a discussion by asking a student to imagine a situation where institutions do less to protect their investment. One simple method is to have students imagine that their college registrar has the habit of changing graduation requirements every few years. If all registrars acted this way, how many students would seek to enroll in college? What would happen to the number of educated adults? What would happen to economic productivity? „ Chapter Answers 1. In Country A, where profits are subject to confiscation by the government, few people would choose to enter mining. While using fewer of their natural resources, the citizens of Country A also would have less employment, lower incomes, and lower production of goods than Country B. Thus, in one sense, while the physical endowments are the same between A and B, the ability to utilize those endowments is considerably lower in A than B. 2. Often, situations like the one asked about in this question arise from a desire for income or wealth equality. Much of the rationalization for these policies ignores the importance of property rights. For instance, if we should confiscate miner’s profits so that all in society can benefit, then miners will choose to reduce the amount of ore mined. The end result is that no mining occurs, no profits are taxed and no income is generated, which perversely achieves the goal of equity espoused by the group that wants to redistribute resources. 3. This law would have far-reaching consequences. I will endeavor to outline only a few. A first reaction might be to think that migration out of the state of college-bound students will occur. To any extent this happens, this will benefit surrounding states, which will increase their talent pool in college and future labor markets. Of course, this will decrease the academic talent in the subject state. The decrease in college applicants may cause in-state universities to lower tuition, which would attract out-of-state students (who probably wouldn’t stay in state to work upon graduating) and perhaps induce some in-state students to remain (especially if they were likely to move out of state upon taking a job). At the same time, hoping to receive the benefits of the higher tax base, it is likely that non-college-bound citizens will move to this state, which perversely from the governor’s standpoint would drive down the wages of those not attending college and, possibly, make the wage gap between education levels larger. Campaign contributions to the governor are more difficult to predict. Parents of students who have been driven from local colleges will dislike this policy, as will citizens who support higher education in that state. On the other hand, those not subject to the tax may think their overall tax burden will fall and thus be in favor of the governor. These individuals are likely to be disappointed, though, given that the governor will probably not earn significant tax revenue from this policy because college graduates are less likely to remain in the state.

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    Chapter 1: Rich Nation, Poor Nation 1-3 4. Note: All figures calculated using PPP. Source: CIA World Factbook. 5. This chapter stresses the importance of property rights. In this light, aid in the form of capital may have less of a positive impact than the giving nation hopes. Capital that can be transferred or confiscated may not be used optimally. For instance, when property rights are guaranteed, an individual given a tractor may be more likely to buy a field and work it. Absent property rights, a farmer is less likely to buy the field and the tractor becomes less useful. Grants of consumer goods may reduce incentives for individuals to create their own consumer goods, which in turn may reduce political pressure to force governments into protecting property rights. 6. In 2016, Louisiana had a per capita personal income of $43,487 that ranked it 36th among the 50 states and DC. In 2013, Quebec had a GDP per person of CAN $46,126 that ranked it 10th among the 13 provinces and territories. Both are below their national GDP per person averages. 1 1 Information for Louisiana: http://www.bea.gov/regional/bearfacts/action.cfm?geoType=3&fips=22000&areatype=22000 Information for Quebec: https://en.wikipedia.org/wiki/List_of_Canadian_provinces_and_territories_by_gross_domestic_product (Sources from Wikipedia were based on information provided by Statistics Canada and Canada Revenue Agency.) 2016 Real GDP Per Capita Common Law Nations Civil Law Nations Australia 48,800 Brazil 14,800 Canada 46,200 Egypt 12,100 India 6,700 France 42,400 Israel 34,800 Greece 26,800 New Zealand 37,100 Italy 36,300 United Kingdom 42,500 Mexico 18,900 United States 57,300 Sweden 49,700

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    2-1 Chapter 2 Innovation and Growth „ Chapter Overview Innovation is necessary to transform prior inventions into something useful for our everyday lives. Profit is the incentive for businesses to innovate and, when firms are successful, our standard of living increases. It is the introduction of new products that improves our lives and it is the potential profit for businesses that leads to new investment, which contribute to economic growth. Property rights to ideas must be secure and being able to keep the fruits of one’s labor are necessary in order to create the proper incentives to innovate. Governments need taxes to operate but the unintended consequence of taxing profits is that there is less incentive for firms to innovate. „ Descriptive Analysis Each of us today benefits from prior inventions and innovations to those inventions. We can communicate with each other or send pictures to each other from across the world; we are able to obtain information in a matter of seconds that previously took hours; we can purchase groceries, other essential home products, and even electronic “toys” that entertain us at much lower prices due to innovation. Innovation either reduces production costs, which leads to lower prices, or it brings us new goods and services that make our lives easier or give us more utility (pleasure, satisfaction). Just because someone invents something does not mean it will automatically reach the masses. In fact, some inventions in hindsight seem to be useless or have only narrow applications. It is innovation—the process of transforming the invention—that leads to the increase in the welfare of the masses. Innovation does not just happen by chance. In fact, inventions and innovation are a function of how much is spent on research and development (R&D). Large, private firms and government agencies spend billions of dollars on R&D trying to create new inventions, but only a few actually are created that have useful applications, and even fewer might be successful commercially. However, not all innovation is done by large firms or government. Small businesses and individuals invent and innovate, too. Regardless of whom does the R&D, our standard of living increases when new products are brought to market and when innovation transforms already made products or lowers production costs, which lead to lower prices for consumers. These lower prices, in a very real sense, are equivalent to getting a pay raise. Historically, when the rate of innovation was slow in the United States, the standard of living was low. However, as the rate of innovation has increased, so has the standard of living for the average American. It is innovation that is the foundation for economic growth. Innovation does not just happen in any economic system. The institutions (rules of the game) of a country affect the incentives to

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    Miller, The Economics of Macro Issues , 8 th Edition 2-2 innovate. If there is no stable judicial system that enforces property rights such as patents, then firms and individuals will not have an incentive to invent or innovate. Moreover, if taxes are imposed on the profits of large firms or small businesses, then the incentive to create a better product or to innovate will be diminished. The notion that everything important has already been invented ignores the fact that previous inventions and innovations were built on previous knowledge. So, the fact that we have more inventions and innovations today than ever before means that there is fertile ground for even more inventions and innovations that will improve and change our lives. „ Teaching Tips Students might not appreciate how their lives have been impacted by entrepreneurs who had an idea and made it into the “next big thing.” Our lives today are so much easier and we have so many more products that entertain us, allow us to communicate more easily and more productively, or even go on dates. You can use the television show Shark Tank on ABC as an example. Ask your students why they think these people come on the show? (They will most likely say, “To make money!” and that’s fine. It is this pursuit of money for themselves that gives others the value-enhancing goods and services.) Students might underestimate or negatively view the pursuit of profit. Some students might protest that profits are “evil” and companies take advantage of us. But then ask students if they need their iPhone or Sony PS4/Microsoft X-Box video game console that is currently in their hand or in their dorm room? Ask them if Apple or Sony or Microsoft forced them to buy their product? You can also turn the tables by asking them if they would go to work if they did not receive a paycheck. What you want your students to understand is that those firms and individuals who invent and innovate respond to incentives just like they do. This is also a good time to remind students of Adam Smith’s famous quote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” It is because of their own interest, that we don’t have to produce our own steak, bread, or beer that we enjoy eating and drinking. „ Chapter Answers 1. It is better to live today. If the famous kings and queens of the past or John D. Rockefeller got sick or suffered from medical problems, they were worse off than the average person today who can get high-tech medical treatment and medicine. Individuals today can get better relief by just going to the pharmacy let alone to a physician who has much more human capital and physical capital to work with today than during the times of the kings and queens or Rockefeller. As far as homes, cars, communication devices, and entertainment products, the average income- earner today lives in a safer home, drives a more luxurious and safer car, can communicate both verbally and visually with anyone across the globe, and can enjoy a beautiful high-definition picture on their flat television. 2. Human beings are always thinking of new things to create or devising ways of making a better mousetrap. The problem is that just because someone invents something, it does not necessarily mean others will benefit from it. First, the invention has to be something that truly has a benefit. Moreover, in order for it to be commercially successful, it has to benefit many people. This is why innovation is necessary and not just invention.

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    Chapter 2: Innovation and Growth 2-3 3. It depends on who does the spending. One can argue that government expenditures on basic research are necessary since private firms will not undertake this. On the other hand, government R&D can be wasteful since they are spending taxpayer dollars and not their own money. Therefore, the government agencies doing the R&D might not be as good of stewards with their resources. On the other hand, it can be argued that if our knowledge has increased due to R&D, even if it isn’t profitable, that knowledge will make us better off and lead to more productive avenues of R&D. Of course, private firms have the financial incentive to spend time and money researching and developing products that will make a profit. And if the firm makes a profit, that is evidence that they did something right (solved a problem, alleviated suffering, created something pleasurable) since individuals cannot be forced to buy the products of the firms. 4. Economic growth has an impact on individual welfare. Even small percentage changes, due to compounding, have a large impact. So, while a small change might have a small impact on our lives in the short-run, in the long-rung our standard of living will be greatly reduced. There is an easy way to determine the number of years it takes for an economy to double in size. The formula is equal to 70 divided by the growth rate (the rule of 70). So, using 2.1%, it would take an economy approximately 33 years to double; however, using .9 %, it would take approximately 78 years. 5. In Nation A, the after-tax profit will be $83,000 ($100,000 × .17 = $17,000) while in Nation B it would be $93,000 ($1000, 000 × .07 = $7,000). Therefore, the preferred location is, of course, Nation B (assuming everything else is equal). The business is not the only one that will benefit by operating in Nation B—the citizens will also benefit. First, the business in Nation B will provide a service or product that can be directly sold to the citizens of Nation B. Second, the business will have to hire workers from among the citizenry, thereby increasing employment in Nation B. Finally, the business in Nation B will invest in physical capital and will continue to innovate which will lead to more growth. 6. Answers will vary but most likely students will list the iPhone/Android phone, popular apps like GPS navigation (Waze) and online banking, social media and dating, websites, improved video game graphics, picture quality on televisions, online education innovations, and improvements in medicine. It is difficult to put a precise dollar value on psychological utility, but students at least could be asked to estimate how much money they spent on the above items over the last five years. Students could be asked how much time and money they were able to save by not having to commute to all of their classes on campus or they could be asked to consider how much money they would pay to avoid the pain and suffering they would have without their medicine. Finally, if they met someone online, ask how much that is worth to them.

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    3-1 Chapter 3 Outsourcing and Economic Growth „ Chapter Overview Many business commentators, politicians, and union leaders consider outsourcing harmful to the United States economy. Politicians oppose outsourcing because they are trying protect domestic workers who will be affected by increased globalization. Because the cost is concentrated but the benefits are dispersed, outsourcing is seen as a losing policy for the United States. However, per capita income for citizens is higher in countries that engage in international trade and outsourcing. „ Descriptive Analysis Business commentators and politicians, both Republican and Democrat, argue that “Made in America” is good for the United States economy. Therefore, outsourcing is depicted as harmful because it “sends jobs overseas.” Outsourcing is simply hiring foreign workers to do the same jobs as some American workers. Of course, this reduces labor costs for firms that outsource. Outsourcing is just another part of international trade. People do not realize that when they watch a hockey game where the Detroit Red Wings play the Vancouver Canucks in Detroit, that Detroit fans are outsourcing labor services from Canada. Trade creates wealth. This concept applies to two individuals who engage in voluntary trade or two countries that trade. However, governments impose trade barriers such as tariffs and quotas in order to protect domestic jobs. The empirical evidence is clear that countries that engage in international trade have higher annual growth rates of per capita income. Yes, there are losers when there is free trade; however, the winners outnumber the losers. Some opponents of outsourcing even claim that the United States will become a Third World economy because of cheap labor in other countries. The problem is that critics of trade are focusing on one group, not all groups. It is easy to see the pain of outsourcing when a company moves its production facilities overseas. It is harder to see the benefits of trade and outsourcing to millions of consumers in the form of lower prices. In addition, lower prices means Americans have more money to spend on other American products. The discussion regarding outsourcing ignores that it is the result of trade liberalization among nations and that prices adjust to keep markets in balance. Outsourcing to other nations means that the people in those countries will then have more income to demand American products. The other main point is that as the countries that we are outsourcing to become wealthier, then their wages go up and they become less competitive in the labor market. For example, China now outsources labor to Vietnam and Cambodia.

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    Miller, The Economics of Macro Issues , 8 th Edition 3-2 United States firms are not the only ones that outsource. German companies like BMW and Mercedes-Benz and Japanese companies like Honda have set up production facilities here in the United States. American radiologists are hired by other countries to read MRI images. These are all examples of insourcing. While outsourcing does eliminate some American jobs, in the long run it creates more jobs. Every week about one million people lose their jobs; however, every week more than one million find a new job. This dynamic activity in the labor market is a sign of healthy economy. There are countries that try hard to protect their jobs with restrictions on trade and other labor regulations. This has actually resulted in higher unemployment in those countries. „ Teaching Tips Ask students if they pay others to do things that they can do themselves. You can use examples like having papers typed for them, changing car oil, or growing their own vegetables. Then ask them if they feel that they are being harmed by “outsourcing” these services. „ Chapter Answers 1. In reality, there is no difference. We do not normally hear about Michigan workers taking car jobs away from Florida workers just as we do not hear about Florida orange workers taking jobs away from Michigan workers. The reason is that Michigan and Florida are both part of the same country. Of course, when the example is the United States and China, the logic seems to be discarded. Trade based on comparative advantage and outsourcing not only benefits two different states but also two different countries. The problem is that good economics and good politics do not always go together. 2. Presumably, BMW is not opening a plant in the United State due to benevolence. It is clear that the German company is winning by making their product here. In addition, US workers are winning because Americans are working at the BMW plant not Germans who commute to the United States from Germany on a daily basis. 3. IBM’s main goal is to make a profit, not provide jobs to Americans. Due to labor cost differences, IBM can reduce their costs by outsourcing. The short-run cost is that some Americans (e.g., programmers) will lose their job; however, IBM can expand in other areas due to cost savings thereby increasing employment for other Americans. Moreover, IBM can pass down the cost savings in the form of lower prices to consumers. Now consumers of IBM products have more money left over to spend on other American businesses. 4. The losers are the employees in India who lost their jobs; the winners are the Americans who have replaced those Indian workers. As the Indian economy grew, wages increased. This wage increase reduced the competitive advantage of the Indian worker over the American worker. Of course, the companies doing this are taking actions that maximize profit. This in turn benefits all the employees of the company who still get a paycheck. 5. Germany is outsourcing its labor to the United States. When the cars are produced in the United States and sold to China, it is counted in US GDP as Net Exports. 6. Outsourcing is a form of international trade. Restricting outsourcing is similar to a government imposing tariffs and quotas. Free exchange is prevented or greatly reduced. The winners are typically well-organized special interest groups because the benefits to them are concentrated; the losers are the millions of consumers who are not organized and who do not see the obvious benefits of free trade and outsourcing because those benefits are dispersed.

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    4-1 Chapter 4 Poverty, Capitalism, and Growth  Chapter Overview While it is easy to see that wealth can be accumulated quickly by a few “lucky ones” in capitalistic countries, it is more difficult to evaluate how the poor in these countries fare relative to the poor in other nations. Do the poor in capitalistic countries do better than those in countries following other economic systems? Does capitalism tend to improve the poor’s standard of living? Does capitalism improve the opportunities for movement out of poverty? This chapter provides affirmative answers to these questions.  Descriptive Analysis Since the beginnings of the Industrial Revolution 250 years ago, the ratio of the world ’s population living in abject poverty — that is, on less than = er people live in abject poverty today than fifty years ago despite the doubling of the world’s population. In itself, this simple observation really is the most impressive and important economic fact of the past century. However, a cursory inspection will reveal that these gains have been uneven. For instance, the extent of poverty in some African nations has changed little over this time, while poverty has declined dramatically in countries like China and South Korea. One common thread that explains economic growth is the presence of capitalism. Capitalism allocates resources more efficiently than other economic systems, which tends to encourage economic growth. At the same time, capitalism is often viewed as causing a greater income disparity within a country. If some individuals command a high wage while others cannot, the end result of capitalism may be income disparity. However, when analyzing cross-country data, this does not appear to be the case. First, when ranking countries by the degree of market openness, a number of studies, including that of the Fraser Institute cited by the authors, find that capitalistic countries grow faster than countries utilizing other systems. Within the 40 most capitalist countries in the world, the poorest 10% of residents earn about 2.5% of total income. While there is some variation between nations, when looking across all countries, the poorest 10% of residents receive between 2% and 2.5% of total income. Thus, while the shares may be somewhat higher for capitalist countries, the big impact on the poor is through the better performing rich countries. A 2.5% share of U.S. income provides a much better standard of living than a 2.5% share of a communist country. Further, the higher growth rates experienced by the capitalist countries inevitably aids the poor in those countries. A 2.5% share in a country that is continuously growing implies a much better long-term standard of living than a 2.5% share in a country with little or no growth. It appears that a rising tide (caused by capitalism) lifts all boats. These differences are reflected in other measures of life quality. Life expectancy is higher in capitalist countries, while child labor and infant mortality is lower. All three of these increase the standard of living significantly for the poor. Longer life expectancy allows the poor greater opportunity to accumulate

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    Miller, The Economics of Macro Issues , 8 th Edition 4-2 wealth, while less child labor provides an opportunity for education and growth out of poverty. As a matter of fact, some economists have argued that reducing poverty requires education, which occurs only as poverty is reduced. Non-capitalistic countries that grow slowly and do not provide markets that reward human capital are less likely to see their citizens educating children, and thereby guarantee slow growth and high poverty rates in the future.  Teaching Tips Alan Heston and Robert Summers have compiled perhaps the most frequently used data set to examine economic growth: the Penn World Tables (http://www.rug.nl/ggdc/productivity/pwt/). These are an outstanding resource to instructors wishing to find easy-to-use data that can be shared with students or presented during lectures. The tables contain data on about 30 variables for about 189 countries over some or all of the years 1950-2014. The data provide purchasing power parity and national income accounts that are comparable across nations. The data are easy to access and can be downloaded into an Excel spreadsheet with relative ease.  Chapter Answers 1. The empirical evidence suggests that noncash benefits are more prevalent in wealthy countries than poor countries. The reason behind this is simple: Wealthy countries are more able to fund benefits for the poor than are poor countries. Of course, these types of benefits improve the lives of the poor in wealthy countries relative to those in poor countries. If non-cash benefits are higher in rich countries than poor countries, then the data on average income of impoverished citizens presented in this chapter understate the actual incomes of the poor in rich countries more relative to those in poor countries. 2. It is easy for political leaders to exploit those with little ability to oppose them. In a nation with a rule of law, it may continue to be difficult to protect the poor’s interests, but it is easier than in a nation governed by the whims of the few. In other words, it is relatively less expensive and easy for the poor to enforce their property rights in a system established on the rule of the law than it is for the poor to curry the necessary political favor to accomplish their goals in a system without the rule of law. 3. Certainly strengthening the rule of law is something that could be done to help the poor, as would be methods governments could use to encourage capitalism’s spread. These are difficult events for a foreigner to cause to happen, though. Instead, foreigners could focus on the laws and regulations of their own governments that prevent the poor in other countries from prospering. Perhaps the domestic laws that have the most impact on the foreign poor are the laws that prevent a free exchange of goods and services across borders. For instance, a domestic tariff or quota that prevents foreigners from selling goods in the domestic country has the effect of reducing foreign demand for labor, which in turn eliminates jobs and reduces wages for all foreigners, including the poor. By keeping foreigners from enjoying the benefits of trade, there is less reason to fight for capitalism in the foreign country, as the benefits are not clearly seen. Of course, this can simply prolong the cycle of poverty in those countries. 4. Many factors make implementing capitalism difficult in countries under other regimes. These range from the religious, to historical, to protecting the interests of the ruling class from a more open society. One all too common occurrence is that nations follow a charismatic leader who consolidates political and economic power and thereby deters capitalism.

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    Chapter 4: Poverty, Capitalism, and Growth 4-3 5. Numerous answers can be given to this question; however, some specific reasons include higher government spending since the Great Recession and increased regulations under the last administration. 6. The most recent (2016) rankings by the Fraser Institute (https://www.fraserinstitute.org/studies/ economic-freedom-of-the-world-2016-annual-report) places the Democratic Republic of Congo at a very low 157 out 159 nations on their Economic Freedom Index.

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    5-1 Chapter 5 The Threat to Growth „ Chapter Overview As discussed in Chapters 1 through 4, components to successful long-run economic growth include secure property rights in a system that allows individuals to freely participate in market activities. One possible barrier to free trade between individuals is government involvement in economic decisions. Whether directly through regulation or indirectly through taxation, government involvement in economic decisions may lower social welfare and has the potential for reducing economic growth. Given the recent large budget deficit run by the U.S. government, this chapter argues that a big threat to U.S. growth is a future increase in taxes. „ Descriptive Analysis Over the past decade, the U.S. government has represented an increasing share of the economy. Federal government spending represents one-quarter of gross domestic product (GDP). Combined with increasing shares of state and local government spending, all governments in the U.S. account for almost one-half of GDP. The reasons for this expansion are many including war, recession, expansion of entitlement programs, and subsidies. What is obvious from this experience is that taxes have not risen to meet increased government spending resulting in growing budget deficits and debt. Regardless of changing the amount of government spending, the economy’s budget constraint remains unchanged. In other words, U.S. output is dictated by the amount of labor, capital, entrepreneurship, innovation, and human capital available at any given time. As the government expands, the production created by these inputs are redirected from consumers, investors, and foreigners to the government. This occurs regardless of if the government pays for goods using tax revenues or by using borrowed funds. In short, increased government spending is paid for by citizens either immediately through taxes or over time through increased taxes used to repay borrowed money. At first glance, it may appear that increased government spending has no impact on economic growth. After all, if the government spends taxed money something is being purchased and, presumably, the citizen who was taxed is not spending. This is much like robbing Peter to pay Paul; Peter (the citizen) does not spend but Paul (the government) does. However, this analogy is not correct. The act of taxing Peter may influence Peter’s decisions in such a way as to reduce Peter’s future economic productivity. Because the U.S. government is in debt, it will need to repay that debt through increased future taxes. Higher taxes reduces the incentives for citizens to work, innovate, and invest. In short, increased tax rates reduce the after-tax profits individuals earn on their economic activities and thus discourage the pursuit of those activities. The end result is that higher government spending today coupled with increased deficits produces higher future taxes and lower economic growth rates.

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    Miller, The Economics of Macro Issues , 8 th Edition 5-2 The link between higher taxes and reduced economic growth is straightforward to understand. First, consider a potential investor choosing between investing in a project that will create some future returns and spending on a consumable good today. An increase in taxes reduces the after-tax returns on the investment and makes that investment less desirable relative to consumption. The end result is a reduction in investment demand and, in equilibrium, less capital created. Less capital means fewer inputs to production to create future GDP. The same occurs in labor supply decisions. Individuals choosing between working and an alternative (leisure, school, etc.) weigh the benefits and costs of each. Increased taxes reduce the benefits of work and make supplying labor less attractive. Individuals who were deciding between working and not working will be less likely to work; those deciding between working overtime and not may be less likely to work overtime. In short, higher taxes reduce labor supply and again, reduce inputs to production. While lower economic growth in and of itself is a poor outcome, one should remember that this is the result of increased government purchases. If those purchases benefited society more than the decreased future growth, then the government spending may be economically efficient. „ Teaching Tips The connection between tax rates and labor supply is easy to demonstrate in a class if you are willing to pay out a small amount of cash to a student. One way to do so is to create an auction for student labor to do a menial task during every remaining class in the semester (clean the chalkboard, etc.). Start with a high price ($5) and ask how many students would be willing to receive that price in exchange for completing the menial task. Reduce the price and count how many students supply labor. Repeat this exercise and graph the labor supply curve. Finally, repeat the entire exercise after imposing a 25% income tax. Graphing both resulting labor supply curves demonstrates a decrease in the effective labor supply curve under an income tax. It is easy to generate discussions involving the equilibrium effects of an income tax (lower employment, raise the hiring cost of labor) and you get somebody to clean your blackboards for you. „ Chapter Answers 1. Higher debt implies that future taxes will be higher, though the extent of this increase is unclear. If the government can perpetually borrow to make payments on its current debt, then the timing of higher taxes can be postponed, perhaps indefinitely if the government’s ability to borrow remains unimpeded. For instance, if the economy grows quickly, individuals may have both the ability and desire to make additional loans to the government. However, for most countries, including currently Greece, Spain and Italy, eventually investors are unwilling to lend to governments and these governments respond by raising taxes and by reducing expenditures. The end result seems to be that more debt today leads to higher future taxes. 2. Any tax reduces the incentives for individuals to pursue the thing being taxed. A wealth tax will reduce the incentive to accumulate wealth, or at least cause individuals to try to avoid the tax (either legally or illegally). One possible response would be for individuals to reduce their net worth by borrowing against paid-for assets. Another, which appears to be happening in some European countries, is for the very wealthy to renounce citizenship and leave the country. Ultimately, a wealth tax will have long-run consequences on citizen’s work effort and holdings of things considered wealth by the taxing authorities.

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