Debt forgiveness that would reduce debt to GDP ratios in the PIIGs to a maximum of ~80%
A contemporaneous recapitalization of European and global banks that would enable them to absorb such debt forgiveness
Credible structural reforms to non-competitive European economies
A mechanism for orderly exit from the EMU as well as pre-agreed criteria as to what would trigger such an exit
Forbearance of punitive fiscal austerity measures in peripheral economies until such economies had reached pre-agreed nominal growth levels

The Current Economic Problems are more Political than Economic

While the political dimensions of the economic crisis are a cause of concern to many, a problem of political will is actually much better than a problem of ignorance: At least we know what needs to be done. What is interesting is that when you get a group of smart, reasonable people around the table, there is a broad consensus with regard to what should be done. Essentially, we should ease the short term fiscal retrenchment and focus on long term structural reforms and fiscal consolidation, which would include

1. Capitalizing all pensions, raising the retirement age to 70 and indexing it with life expectancy

Pension systems were originally built with pay-as-you-go systems where current workers pay for current retirees. The system was sustainable while the number of workers was increasing either due to the baby boom, the entry of women in the workforce, or before countries finalized their demographic shift to stable low birth rate, low death rates. However, a combination of lower or stable retirement age, decreases in fertility rate and higher life expectancy (life expectancy in the US went from 60 in 1930 to 79 in 2010) have significantly increased the number of retirees per worker making them unsustainable at the current benefit level.

In 1950, there were 7.2 people aged 20-64 for every person of 65 or over in the OECD countries. By 1980, the support ratio dropped to 5.1 and by 2010 it was 4.1. It is projected to reach just 2.1 by 2050.

The solution is to make people save for their own retirement. Most private employers have already moved from defined benefit to defined contribution pensions. Using behavioral economic tricks such as opt-outs instead of opt-in, it’s actually possible to make people save enough for their retirement. Public pensions should now all be capitalized as well to make them sustainable especially since they currently make payouts with implied 8% returns which are completely unrealistic.

To handle the transition from a pay-as-you-go system to a fully capitalized system, the new generation of workers essentially has to pay twice: once for their own pensions and once for the current workers. The only way for this to be affordable would be to move the retirement age up to 70 and index it to life expectancy. To make it more palatable workers currently aged 55-65 could retire at 65, those 40-55 could retire at 67 and those below 40 could retire at 70.

Note that the move to capitalized pensions is an efficacy suggestion and does not have implied value judgments on equity. The state should contribute a share of the retirement to those who earn too little to save effectively for themselves. Societies should build sustainable and efficient welfare systems and independently decide how generous they should be. The Nordic countries have capitalized their pensions and chosen to be generous with the needy in terms of state contributions to the retirement accounts of low income earners. As such they ended up being more generous to low income earners for much less than the cost of pensions much less generous countries with pay-as-you-go systems.

2. Massively simplifying the tax code, broadening the tax base and lowering marginal tax rates

The tax code in most OECD countries is horrendously complex. The US Federal Tax Code went from 504 pages in the late 1930s to 8,200 pages in 1945 to 71,684 pages in 2010. The compliance cost alone for the Federal Income Tax was estimated at over $430 billion – excluding changes in consumer behavior that diminish overall economic efficiency.

Marginal tax rates move up and down with income seemingly randomly in a totally non-sensical way. Marginal tax rates are too high – an issue given that the dead weight loss increases at the square of the tax rate.

Moreover the tax base is too narrow. 1% of tax payers contribute 37% of taxes federally and as much as 50% for states like California. This is triply dangerous:

• It leads to wild fluctuations in tax revenues given that the income of the 1% is more volatile than those of the middle class forcing states especially to make counterproductive pro-cyclical cutbacks in recessions

• It incentivizes the 50% of people who don’t pay taxes to vote themselves ever more benefits

• It potentially gives political power to a small percentage of tax payers

In addition to Hong Kong and Singapore, most Eastern European countries successfully moved to flat taxes. While a flat consumption tax is probably the most efficient, a flat income tax, as employed in Eastern Europe would be much more efficient than the current system and easy to setup given that people already report their income.

They work by taxing a flat % of all your income at the same rate, after excluding a certain dollar value of income. For instance it has been estimated that a 20% flat tax which would exclude the first $20,000 of income would generate as much revenue as the current federal income tax. Under such a system someone making $20,000 would pay $0 in taxes, someone making $40,000 would pay $4,000 in taxes ($40k – $20k = $20k in income * 20%) and someone making $120,000 would pay $20,000 in taxes.

All exemptions and deductions would be eliminated. Not only do these deductions distort behavior and add complexity to the tax code, for the most part they are a subsidy to the rich given that they benefit those who pay the most taxes. The ridiculous disparity between $1 of income from labor or capital gains would be eliminated. $1 is $1 regardless of how you make it. Policy objectives would be achieved through direct transfers or benefits to those we intend to receive them rather than indirectly through tax cuts. As a result your tax return would literally be one page.

For simplicity and to avoid gaming the system, corporate taxes should be set at a low rate, probably the same rate as the flat tax. In theory there should be no corporate tax as it’s essentially a double tax on employees’ salaries and on shareholder income. However, not having a corporate tax would create an incentive for people to minimize their notional income (salaries) and to receive them indirectly in the form of expenses paid for by the corporation.

Beyond the flat tax, the tax system would be used only in cases where the marginal private cost is below the marginal social cost. For instance a combination of carbon taxes, fuel taxes and congestion charges would alter economic behavior as it would make drivers bear the full cost of their activity. These are much more efficient than providing subsidies and tax cuts to alternatives since politicians are incapable of choosing which technology to back and the subsidies often become unaffordable as the businesses scale as Spain has learned to its expense with its solar subsidies. It has been estimated that in the US the fuel tax should be $1-2 per gallon rather than the 18.4 cents per gallon that it is now.

3. Very liberal immigration policy

Nearly half of the startups in Silicon Valley were created by immigrants, mostly of Indian and Chinese descent. Nowadays, after they finish their undergrad or PhDs, they are sent back to India and China and create companies there. From a global welfare perspective it’s probably net neutral, but from a US welfare perspective it’s completely idiotic.

The reality is that immigration controls have no impact on unemployment be it of skilled or unskilled labor because the demand for labor is not fixed. If the supply of labor increases, the demand for labor increases as well. Those who suggest otherwise commit the lump sum of labor fallacy.

The empirical evidence clearly suggests that immigration even of unskilled labor is a net positive for this country (Immigration and the Lump of Labor Fallacy). This happily ties with my personal value judgment in favor of equality of opportunity and my admiration for those willing to bear the huge fixed costs of immigration – leaving their family behind, coming to a new culture in an uncertain environment – to pursue the American dream in the land of opportunity.

Next time, I look at more steps, include in the focus of healthcare to preventative care, as a solution to the European debt crisis.