Turkey
Tax the Rich
Aug 08, 2006

Serhan Cevik (from Istanbul)

Sounds contentious? It really is not, since 58% of income tax is paid by wage earners. An economy is a complex system of relations and its vim and vigour depend on a fine balance. And when that balance is disturbed, the entire system might come under threat. Now imagine not just a one-off disturbance but decades of distortions tearing down the system’s fabric. Any rebalancing attempt after such a deep shock requires simultaneous actions on multiple, interconnected sub-structures. Well, you do not need to stretch your imagination much because Turkey is one of those cases waiting to be given a new lease of life. After suffering from decades of instability that led to a devastating blow in 2001, political stabilisation and rational policies have at last resuscitated the economy. However, although normalisation has paved the way for strong growth and disinflation, ‘doctors’ must move beyond the stabilisation phase and start dealing with underlying ailments. In our opinion, the mother of all problems in Turkey is archaic public administration and the resulting fiscal imbalances. Almost every macro or micro problem is a direct or indirect result of the superseded state of the Turkish state. Take, for example, the budget deficit that widened to 16.5% of GDP, distorting the market economy. In midst of the crisis, the authorities relied on short-term measures — cutting spending and raising indirect taxes — and lowered the deficit to less than 2% last year. But that was just a quick-fix giving time to address the real problems: inefficiencies in spending and inequities in tax collection.

Turkeyhas the worst taxation structure among OECD countries. The ratio of tax revenues to GDP standing at just above 30% may suggest a low tax burden compared to other countries. Unfortunately, nothing can be further from the truth. The current tax system gathers total revenues from a narrow base of taxpayers through regressive channels at distortionary rates. With an increasing dependence on indirect taxes, the tax structure has become less productive and more distortionary. The share of revenue from indirect taxes increased from 37.5% in 1980 to 68.5% — significantly above the average of 54% for all developing countries. Correspondingly, direct taxes now account for just 32.5% of total tax receipts, down from 62.5% in 1980. Especially over the course of the last 15 years, the share of revenue from income taxes has declined from 32.9% to 15.5% and the share of revenue from corporate taxes from 8.2% to 6.5%. Furthermore, the composition of ‘tax-paying’ taxpayers is continuously getting worse. Today, wage earners pay 58% of income taxes, sharply up from 37.2% in 2001. And on the corporate tax front, the situation is no different. The top 100 firms pay 58% of corporate taxes, and 19 of these are state-owned enterprises accounting for 30% of corporate tax revenues. Put differently, 4.2% of Turkish firms pay 87.8% of corporate taxes in the country.

The archaic tax system has created a haven for evading and avoiding taxes. As a developing country, Turkey needs to channel more funds to infrastructure and education and cut employment taxes (which exceed even those in Sweden) in order to improve the economy’s labour absorption capacity. But it cannot do that without creating fiscal imbalances. A catch-22? Not really, since the problem stems from the fact that those who earn most pay the lowest proportion of taxes. Because of the tax system’s failures in monitoring and enforcement, the ratio of under-reported income to actual income increased from 21% in 1996 to 54.8% last year. By analysing income tax data, we found that financial advisors and accounts, lawyers and doctors pay, on average, 6.6%, 5.1% and 4.7%, respectively, of a notary’s annual tax bill (see Of Taxes and Ferraris, October 11, 2005). We can give you even more examples of widespread tax evasion, but our favourite is more than enough to give you an idea about the extent of the problem: 89% of self-employed including firm owners claimed a monthly income below the poverty line!

Tax evasion is a burden on the budget and also worsens social disparities. The vast scale of tax evasion and avoidance, especially on non-labour income, is a serious encumbrance on fiscal management and also worsens income inequality. Even though there has been some improvement in aggregate income figures in the past couple of years, social disparities remain discouragingly wide. For example, the income of the wealthiest 1% of the population is 260 times more than what the poorest 1% of households earns in a year. In our view, this extraordinary disparity is a direct result of enormous capital gains the rich have enjoyed over the years without paying much tax. Indeed, considering the drop in the share of taxes on financial earnings to 20% of income tax receipts, after-tax income distribution is even worse. So when we say “tax the rich”, we do not suggest a progressive tax system with escalating tax rates for higher levels of income and assets. Instead, we think that Turkey needs a simplified, modern tax code and administration that would minimise evasion and avoidance. With a better collection of appropriate taxes, the state would have enough funds to focus on the most important determinant of income inequality and poverty risk: education.

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Latin America
The China Link
Aug 08, 2006

Luis Arcentales (New York) and Heloisa Marone (New York) and Daniel Volberg (New York)

Latin Americais in the midst of its most significant trade boom in a quarter of a century.  Indeed, the total trade of goods expanded by a staggering 43% over the past two years, a performance not seen in the region since the early 1980s. The current trade boom, however, has not been limited to Latin America and its main trade partners.  Our chief economist Steve Roach notes that since 2001, the ratio of exports to world GDP rose by 4.0% points to 28.1% in 2005 – the sharpest four-year increase in over 30 years (see Doha Doesn’t Matter, Global Economic Forum, August 4, 2006).  And few economies in the world have been more important to this powerful trade dynamic than China.

China’s increasingly important role in the world economy has left its mark on Latin America’s external sector. Since 2000, China’s share in world merchandise trade has risen by about two-thirds to 15%.  From Latin America’s standpoint, China’s importance rose 2.7 times to just over 4% of trade last year.  As the key swing factor in the global commodity demand equation, China’s insatiable hunger for commodities has greatly benefited Latin American exporters.

But just as the links with China have become stronger, Latin America’s vulnerability to a slowdown in China has naturally increased as well.  It might seem odd that we are exploring the possibility of a China slowdown; after all, Chinese GDP surged 11.3% in the second quarter — the strongest quarterly figure in a decade.  Yet in today’s increasingly integrated global economy, rising fears of a US slowdown and the potential impact on China’s export and investment-centered growth dynamic cannot be overlooked (for our latest outlook on the US, see Dick Berner’s A Tough Call for the Fed, US Economics, July 31, 2006).

To address the impact of a potential China downturn, we decided to look at the importance that China has played as an export destination for goods from Latin America.

The export link

There is no mistaking the rapid growth of China as a destination of Latin American exports.  In the past five years, merchandise exports to China have grown at a 45% average clip – nearly five times higher than total export growth from our region.  Meanwhile, China’s share in Latin America’s exports has increased fourfold over the same period.  Though at 4.1% of total exports in 2005 it is still modest, it accounted for just under 10% of total export growth for the region last year.

Aggregate trade data mask sharp intra-regional differences, however.  While China’s weight as an export destination has grown broadly across the region, its relative importance varies significantly.  As the key swing factor in global commodity demand, important metal exporters like Peru and Chile have the highest exposure to China.  In both Peru and Chile, China now represents nearly 10% of all export demand.  Not surprisingly, countries whose export basket is centered on mining and agricultural goods have seen China grow in importance the most.  In Brazil’s case, for example, China is now the third-largest export destination, up from 12th as early as 2000. 

Given the special nature of the oil market linkages, it is not surprising that Venezuela, Colombia and Mexico have only weak export links to China.   In addition, Mexico also has the highest concentration of manufacturing goods, which compete more directly with China.

The experience of 2005 underscores China’s predominant role as the driver of global commodity demand.  As Steve Roach notes, China emerged as the largest consumer of copper, nickel and zinc last year.  Chinese consumption accounted for 50% of the growth in aluminum consumption and 84% of iron ore, to cite two examples.  These results are all the more impressive if we consider that China accounts for just 4.5% of world GDP at current prices (see A Commodity-Light China, Global Economic Forum, June 2, 2006).

While part of the growth in China as trading partner has come at the expense of Asia, in the case of Latin America that has not been the dominant story.  Between 2000 and 2005, Asia’s share of Latin American exports rose from 5.5% to 9.1%.  Though this gains pale in comparison to China’s — whose share rose fourfold to 4.1% in 2005 — the relative importance of Asia ex-China also gained ground, albeit modestly.  And the message from Asia’s exports to Latin America is similar: part of the gains has come from the reallocation of assembly plants to China from other Asian countries, but overall our region’s trade linkages with Asia have strengthened.  On balance, the main driving force has been an increase in Latin American exports to China, underscored by a sharp reversal of the trade deficit late last year.

Imports

While China’s impact in Latin America is usually viewed from the perspective of its standing as a growing export destination for Latin commodities, China has also benefited the region by contributing to lower inflation.  While China is often held up as having boosted countries from Brazil to Chile even as it has competed and often taken away market share for Mexican exports, across the region China’s imports have risen sharply.  Interestingly, the relative importance of Chinese imports mirrors that of exports, with Chile and Peru the highest among Latin America’s major economies.  Since 2000, China’s penetration in Latin America’s imports market has roughly doubled to 4.2% of total imports. 

The increase in imports from China has come as inflation in the region has been reduced, which in turn has helped usher in an era of lower interest rates.  Although we are currently seeing a cyclical uptick in interest rates in the region — with the noticeable exception of Brazil, where rates are likely to continue to fall, and Mexico, where we suspect the next move by year-end will be to lower rates — the improving inflation picture has contributed to enhanced credibility in monetary policy and to greater credit growth.  That, in turn, has boosted consumption, including demand for Chinese imports.

Bottom line

Latin America’s growth boom of recent years is more than just a derivative story brought on by the growth in Chinese demand.  Even today, China represents somewhere just over 4% of total exports from the region and, even in countries where the concentration is the highest, China accounts for at most 11% of exports.  But those seemingly modest numbers represent a six-fold increase in Chinese demand for Latin exports in the past five years. 

Meanwhile, Chinese export demand is fairly lopsided in the region, with four countries — Chile, Peru, Argentina and Brazil — representing the bulk of the demand; by contrast, the picture is much more balanced for Chinese imports.  Across the region, Chinese imports have represented a secret weapon, which has helped to contribute to lower inflation, enhanced central bank credibility and the resulting boost in credit growth.   Latin America’s vulnerability to a China slowdown has to be measured from both sides of the trade equation.

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China
Development Model and Tightening Challenges
Aug 08, 2006

Andy Xie (Hong Kong)

China’s development model appears to complicate macro management: Local governments dominate China’s development, benefiting from overheating arising from investment, while the central government ultimately bears responsibility for the subsequent bad debts in the banking system. 

 

Monetary policy is the only effective tightening instrument: Even though China’s development model is government-led, as in a private sector-led economy the only effective means of tightening macro policy is through limiting credit and monetary growth.

Administrative measures are not effective: China’s economy has become so complicated that central government administrative measures can only be guidelines.  Local governments can design the implementation rules to circumvent the spirit of the central government tightening measures.

Effective tightening could come externally: China is no longer deflationary for the global economy due to its overheating, and global central banks may tighten more than expected.  Both capital inflows and exports could weaken during global tightening, which would remove China’s excess liquidity and normalize its interest rates.

Summary and conclusions

Local government dominance in China’s economy appears the most important factor in China’s macro behaviour.  Local governments are similar to monopoly businesses that compete among themselves for GDP maximization.  Similar to monopolistic competition in industries with high fixed costs, predatory investment that deters similar investments on the part of one’s neighbours drives the competitive dynamic.  As in a monopolistic competition model, the equilibrium entails excess investment (e.g., the excess capacity is to deter one’s neighbours from investing in a similar industry).

As local governments control key factors in production (e.g., land price, taxes, etc.), even as businesses in each local economy engage in price competition among themselves to maximize their profits, the shares of local government revenues in their economies are really similar to monopoly profits.  This could explain why the household sector’s share in China’s economy continues to decline.  In a sense, China’s savings are driven more by local government than household behaviour.

In addition, local governments can raise debt or equity capital through their affiliated businesses.  Economic overheating is a by-product of investment funded by these means.  When liquidity is loose for cyclical reasons, monopolistic competition compels local governments to raise as much money as possible to fund fixed investment that would cement their competitive position against their neighbours.  Overheating means more overcapacity.  The usual indicators for overheating in a market economy (e.g., CPI inflation or current account deficit) do not apply.

China’s micro model has made macro tightening difficult.  First, local governments can create a fait accompli by starting numerous projects to deter macro tightening by the central government, as cutting off liquidity would keep these projects unfinished, i.e., there is a massive fixed cost of macro tightening.  Second, local government leaders often have a more senior rank than their regulators in the Communist Party hierarchy and, hence, have a major say in macro policy.  This is why China’s macro tightening has been irresolute since it began in April 2004.

Effective tightening in China is thus likely to come externally.  Capital inflows and exports have driven China’s overheating as they define excess liquidity.  As China is no longer holding global inflation down, major central banks will have to tighten much more than expected, which would decrease capital flows into China and weaken China’s exports.  These would likely happen simultaneously.  Thus, export watching is the most important exercise in assessing China’s cyclical outlook, in my view.

China’s monopolistic competition model for development

Power devolution from central to local government is the most important anchor for China’s development success; but, it has also brought a host of challenges that are unique to the country. 

For example, despite mounting concerns about its sustainability, China’s investment boom has essentially kept going since 1992, with a small correction between 1996 and 1998.  Moreover, China’s current account has gone into massive surplus despite the rising share of fixed asset investment (‘FAI’) in its GDP, which implies that China’s gross savings have risen even faster than its FAI or the gross savings rate has been rising. 

Government-led development is essential in the early stages of development.  The US in the 19th century and Japan in the 20th century showed a similar phenomenon.  The rationale for government involvement is that risk is high in the early stages of economic development, and the fixed investment is high relative to market size. 

What sets China apart is the extent of government dominance.  The monopolistic competition among GDP-maximizing local governments could explain many of China’s unique features.

Unique features of China’s development model

China’s macro characteristics could be explained by its unique micro foundation.  China’s economic development is local government-led.  Local governments are essentially businesses that compete among themselves for GDP maximization.  They are essentially monopoly businesses within their local economies and maximize their revenues through multiple collection channels to fund FAI.  In principle, the bigger the FAI, the greater the future GDP, as GDP is positively correlated with capital stock.  As a first order approximation, FAI maximization is equivalent to GDP maximization.

One characteristic of this model is that the savings rate rises in tandem with the economic growth rate.  High property prices, highway tolls, or sales taxes are not distinguishable from a revenue perspective.  They are just instruments for local governments to mobilize financial resources to fund investment.  Such revenues are pro-cyclical, i.e., they rise faster than the economy when growth rates are above trend and vice versa.  As these revenues tend to fund FAI, their use is also pro-cyclical.  This is why China’s economy is very cyclical, but the current account deficit is not a notable feature of overheating.

A World Bank study (How Would China’s Savings-Investment Balance Evolve? by Louis Kuijs, May 2006) suggests that China’s household savings as a percentage of total growth savings declined from 54% in 1996 to 35% in 2005.  A major factor of the trend is that, since 1998, central and local governments shed unprofitable businesses, consolidated some industries to achieve monopoly power, monetized land and other natural resources to fund investment, and decreased social expenditure in healthcare, education and public housing.

China’s high and rising savings rate reflects its political system that empowers local governments to mobilize resources to maximize FAI.  Unless the political system changes, the trend is not likely to change.

Overcapacity is another by-product of China’s development model.  In monopolistic competition, each business invests more than it expects to use as a deterrent to prevent its competitors from gaining market share through increasing investment.  Such strategic behaviour in competition among regions permeates most aspects of FAI.  Industry clusters, downtown skylines, seaports and airports are some examples.

In such a model, success begets success and growth depends on the snowball effect.  Hence, political power is an essential ingredient for economic success.  Provincial capital cities, for example, are more likely to succeed than other cities.  Shenzhen, Qingdao and Dalian are notable exceptions, however.  The first is China’s first economic SEZ, and the other two are coastal cities in provinces with interior capital cities.

China’s unique macro management challenges

China’s development model creates unique challenges in its macro management.  The usual benchmarks for overheating are not necessarily present in China’s case.  The decentralization of political power could generate an equilibrium path of boom-burst cycles despite its economic inefficiency.

As local governments tend to collect a rising share of revenue during rapid economic growth, China’s household sector has no income base to become overheated.  Hence, CPI that reflects household spending does not rise rapidly during periods of overheating.  Hence, if one looks for CPI inflation as a sign of overheating in China’s economy, it would not be there.

A more relevant indicator is the trend in prices that reflects the investment demand.  China’s overheating began in mid-2003.  CPI has averaged 2.4%, PPI 4.4%, and RPI 8.4% since that date.  The order reflects that overheating expenditure is directed at investment and, especially, construction-related expenditure.

Price indicators that reflect investment expenditure would still not accurately reflect overheating.  Either the central or local governments own most companies that produce investment goods.  The prices that they charge can be kept down anyway — after all, the money comes out of and goes into the same pocket.

The ultimate sign for overheating in China’s model is the rapidly rising share of the government sector in the economy on either the income side, demand side or both.  Hence, tightening in China is really to rein in government-related spending, which begs the question: how can the government regulate itself?

Of course, the Chinese government is not monolithic.  The decentralization of political power among local governments makes macro tightening even more difficult.  Limiting credit growth is likely to restrict capital access for less developed provinces first, which is inconsistent with a major political goal. 

Administrative tightening has become ineffective, as local economies are so complicated that the administrative measures from the centre could only be guidelines, and the implementation rules must come from local governments and could be designed to circumvent the spirit of the central government tightening measures.

Why should China worry about overheating?  The reason is that the available funds during overheating are not sustainable and local governments that start many projects on the assumption that money would remain plentiful could be in for an unpleasant surprise.  Hence, limiting credit now would decrease waste.

Local governments benefit from overheating as they can ramp up FAI as much as possible.  They do not suffer as much from the consequence — namely bad debts.  The central government picked up the tab from the overheating during the previous cycle and is expected to do so again in future.

The irony is that, even though China is a government-led economy, its only effective tightening policy is to limit credit through monetary policy as in a market-led economy.  What makes its monetary policy ineffective is the lack of an independent central bank.

Is it possible to have an independent central bank in a one-party-led economy?  It sounds unfeasible.  However, independent central banks have risen out of necessity in other countries.  It is possible that, after a difficult experience following a period of overheating, China would give the central bank independence.

Efficiency enhancement possibilities

Even though there is much inefficiency associated with China’s model, it is a successful model.  After all, capital formation is the most important factor in the early stages of economic development, and too much capital formation is probably better than too little.  Under-investment is a common problem for developing countries.  China may have too much of a good thing.

Further, China’s inefficiency is probably paid for by under-consumption.  While it deviates from the optimal path, it may not carry serious long-term harm.  Overheating rather than the development model per se poses the bigger risk as it could lead to bad debt and wastage.

However, China could improve the efficiency of its development model structurally and deal with overheating at the same time.  First, China could increase the number of cities that enjoy province status.  Currently, only four cities enjoy such a status.  In a monopolistic competition model, the efficiency level rises with the number of firms. 

Second, China could decrease the ability of local governments to collect revenues.  For example, revenues from selling land and natural resources could be distributed to the population first.  This action alone could decrease China’s savings rate by five percentage points, which would eliminate China’s current account surpluses and cause interest rates to rise by 3-4 percentage points.

Third, China could distribute the shares of the state-owned enterprises among the population.  The transfer of this government asset to the household sector would decrease the household savings rate due to its wealth effect.  It could also limit the ability of local governments to use such companies to fund low-return investments.

Fourth, the central government could crowd out local governments in accessing funds by issuing bonds to fund social expenditure like education, healthcare, or supporting rural development.  By global standards, China under-spends in social sectors even though the government is in excellent financial condition.

In summary, the main threat to China’s economy is overheating as a result of overinvestment, in my view; however, the current political system makes tightening difficult.  The only effective tightening instrument is using monetary policy to limit credit growth.  I believe that there are also a number of structural measures that China can take to improve its government-led development model.

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