Thought Bubble - Tax revenue rather than profits?

I've had a thought bubble, Why do we tax company profits rather than revenue? Before I start I should make clear I'm not considering taxing 30% of revenue, rather calculating the equivalent of 30% based on normal profits.

Taxing companies on profits is a bit like taxing people on disposable income. After all, people are really running their own little business selling their labour. Their health, housing, education, transport are all costs in that business. Take two people earning $45K a year, one is a young person paying off a house or renting, the other is earning a families second income. Many of the basic costs of running their human capital business have already been paid for. If we were to be concerned with fairness we would allow for the differences and tax each person based on their disposable income. Clearly, we don't do this and why would we. We would be subsidising the choices people make and it could be easily manipulated. So why then do we do this for companies?

In our current situation company taxes are a very unstable revenue source for Government. In bad times revenues for company profits collapse as companies report losses and in good times Government revenues boom encouraging unsustainable spend thrift behaviour by Government as we saw in the 2000s. The current system makes the government very exposed to the economic cycle as a company profits are high the amount of taxation government gets goes up dramatically but if the company starts reporting a loss the government gets nothing. The current system also makes the government and other taxpayers exposed to the impact of bad management decisions. As an individuals if my outgoings exceed my ingoings I don't get to stop paying taxation.

What I am suggesting be investigated is a system where we determine a percentage of revenue that is paid in taxation which would be the equivalent of 30% of normal profits. Normal profits are defined in economics as, "the level of profit equal to the opportunity cost of entrepreneurial effort. Normal profits is regarded as the fair reward for the effort the entrepreneur puts into running a firm and the risk that they take on." 


The below table shows the impact switching to a revenue tax would have on taxation revenue. In poor times the government would have more revenue and more room for stimulus and better able to fund automatic stabilizers like increased unemployment benefit. In boom times the temptation to bribe voters with unsustainable spending would be reduced. In this example I assume normal profits of 10%. This could be adjusted depended on industry.

	Profit Tax	Revenue Tax
Situation 1: Normal Profits
Revenue	100,000	100,000
Expenses	90,000	90,000
Profit	10,000	10,000
Tax	3,000	3,000
Situation 2: Expenses > Revenue
Revenue	70,000	70,000
Expenses	90,000	90,000
Profit	-10,000	-10,000
Tax	0	$2,100
Situation 2: Boom Times
Revenue	140,000	140,000
Expenses	90,000	90,000
Profit	$50,000	$50,000
Tax	$15,000	$4,200

Negative Income Tax - An alternative to the welfare system?

I'm currently on holidays and have decided to spend my time productively, watching Milton Friedman's hit 1980s series Free to Choose. http://www.freetochoose.tv/ About two years ago, I stumbled across a copy of the companion book for this series in an OP shop. I quickly grabbed hold of the book and guarded it in case someone else wanted to buy it. Surprisingly, the book looked like it had been on the shelf for a while and it did not create the kind of excitement used copies of Harry Potter can cause. The bewildered shopkeeper seemed surprised at my excitement. On another another occasion a staff member at an op shop seemed amazed when I was clearly excited buying a TI-84 programmable calculator for only $10.

Anyway, Friedman in an episode about the welfare state raised the prospect of a negative income tax. http://en.wikipedia.org/wiki/Negative_income_tax I have provided a link to information on this idea but basically instead of having welfare payments and a massive welfare bureaucracy to administer it, you would instead get paid the equivalent of your tax free threshold and the low income offset in cash if you weren't working and this would be phased out the more income one earns. The idea is that this would remove many of the perverse barriers to work that the interaction between the welfare system and the tax system currently produce. It would also be dramatically cheaper, Centrelink and the Employment Services industry would be largely abolished leaving only minimal paperwork to confirm how much income one earned.

To assess this idea we need to consider how the current welfare system came about. In the early 20th century the welfare system was created with the idea that when people fall on bad times the state will help support them. This is a good idea in theory, however within one generation of the welfare state's creation entire communities became completely depended on the the state. Many people who would choose to work decide not to because the money they can earn in a entry level job does not exceed the value of their benefits and the value of what economists call their leisure time. This is the value people put on the time they would otherwise spend at work, for example a mother being at home with their children. Or they fear losing their welfare payments. A negative income tax would eliminate this second barrier to employment.

In a backlash by the community against those who choose not work, the people have demanded that those on unemployment benefits are forced to look for work and in some cases "work for the dole". It would be fair to say despite some success these programs have not forced many voluntarily unemployed people into work. Equally, many of those with the genuine desire to work have found themselves having to work with a welfare and employment services bureaucracy that is often demeaning and inefficient. Although these programs are popular and make the government look like they are doing something about unemployment they cannot be said to be effective.

Working in the employment services industry I have a vested interest in the current system. However, I feel that the negative income tax system has never received proper consideration and faces resistance from the welfare bureaucracy and the employment services and training sectors. This combined with the fact some people on welfare especially those are receiving what could be classed as middle class welfare will lose out making the idea politically difficult. Another problem is that welfare payments vary between groups. For example, presently pensioners receive more on the welfare system than the unemployed. Clearly, this is due to political reasons and not due to any rational argument that it is cheaper for the unemployed to live than those people on pensions.

The employment and training sector under a negative income tax would be significantly smaller and would be working with clients who have voluntarily chosen to look for work and participate in study. In the show Friedman shows a technical college which is design to equip the unemployed with skills for the labour market. Then like now such schemes had a very low completion rate and had limited success. Any training government provided or subsidised under a negative income tax would only goes to those who choose to do it rather than forced to do it as a way of meeting their activity test as a condition of receiving welfare.

So the question is would a negative income tax, increase the incentive for those to who can work, reduce the humility imposed on those who can't by welfare rules and regulation and reduce the financial cost to the taxpayer? From what I've read and experienced, probably.

Zombie Economics: How Dead Ideas Still Walk Among Us: Review

Zombie Economics: How Dead Ideas Still Walk Among Us is a critique of many of the free market ideas that have defined government policy in the last 30 years. The author John Quiggin a professor of economics at the University of Queensland is a well known Keynesian. The fact Professor Quiggin advocates a return to regulation of financial services and a returned to the mixed economy is not surprising. Taking this into account readers should not expect a balanced account of the pros and cons of the neo-liberal policies that replaced Keynesian policy that had existed since the end of the second world war. The book however, provides a thoughtful critique of some of the ideas that have been used to justify many of the polices carried out in the last 30 years.

The zombies Quiggin slay include, the great moderation, the efficient markets hypothesis, dynamic stochastic general equilibrium, trickle-down economics and privatisation. Despite my free market bias I found myself agreeing with his arguments against the folly that was the great moderation and absurdity that is the efficient markets hypothesis when applied to financial markets.

If history has proven anything, claims that the business cycle has been tamed tend to end in tears. Keynesians made similar claims which ended in the stagflation of the 1970s. Likewise, claims by the advocates of deregulation and the efficient markets hypothesis have ended in the great recession. What seems clear is that at present there exists no economic philosophy capable of taming the business cycle indefinitely.

I first encountered the efficient market hypothesis when studying accounting theory. The argument went, that players in the market have access to perfect information and the financial markets are in the best position to provide valuations of companies. This extended to notion that the marketplace had access to information not publicly available. This was used to justify why accounting standards were unnecessary and that there would a be a market for lemons. Clearly, the collapse of Enron in the mid 2000s and the incorrect valuation of financial assets prior to the 2008 recession should have killed this idea once and for all. Unfortunately, this flawed idea of financial markets being highly efficient is still being peddled to resist regulation of the financial system.

Equally, I found myself agreeing with Professor Quiggin on the trickle down effect, this idea has been used to justify massive tax cuts to the rich. Unlike, Quiggin I believe that reducing taxes on income (the benefit of a person's work) is desirable. He makes the point that at present income rate rates once loopholes in tax law are taken into account the tax system is actually regressive. I would argue that it is better to close the loopholes rather than return the top marginal tax rate to 70%-90%. On the broader point of the trickledown effect, many studies into this area have shown that tax cuts do not pay for themselves through increased growth. Many studies have shown that changes to the marginal rate of taxation has a little impact on the willingness of males to work (Who are usually the major income earner in a family). They do partly pay for themselves but ultimately the costs to a government budget exceed any benefits. Equally, there is little evidence that the poor actually benefit from the rich getting tax cuts. This probably suggests that tax cuts are probably better targeted at the bottom reducing the dis-incentive for people switching from welfare to work.  

The greatest area of disagreement I had with this book was the chapter on privatisation. The book paints a picture of well run profitable government owned corporations being sold off at bargain basement prices and consumers losing out in the process. Quiggin does provide some interesting arguments against privatisation and makes a good case that government often leaves monopolies in place when privatising making it unlikely that efficiencies promised will be realised.

Overall I would recommend this book for anyone interested in economic policy. Even those of us who are friends of the free market have to accept that financial deregulation has contributed to the 2008 recession. I do worry that this book in the wrong hands will encourage ill-informed people to rally behind the idea of the mixed economy with out a serious consideration of its many downsides. A good counter to this book would be Milton Friedman's series and book Free To Choose which highlights the many problems of the mixed economy.

An interview between John Quiggin and econtalk's Russ Roberts can be found here. http://www.econtalk.org/archives/2010/11/quiggin_on_zomb.html

 

Loud music as a Negative Externality

It's the holidays and like most people I have the week off. This is the perfect time for reflection and other other philosophical pursuits. When better to tackle things on the to do list. In my case, I plan to finish my lecture series on environmental economics and learn business statistics.

Day 1, I sit down at my desk and the booming of my neighbour's stereo enters my house through my closed window. This naturally got me thinking about externalities. Clearly, my neighbour was benefiting from his music, it would seem that to increase his utility all he need do is increase the volume. Why, listen to music at a lower volume which his neighbours can't hear when he can increase his own utility by playing the music even louder?

In effect, the sale of stereos that can play music at volumes that can heard by people other than the person intending on listening to it is a form of market failure. Other examples of noise being an externaility includes airports, noise from motorways and industrial noise. Clearly, by the level of political attention these issues get these externalities are no small matter. In some cases taxes have been imposed as a way of compensating local surrounding airports for the increased noise pollution.

So what is the solution to my problem? One option is my neighbour could choose not to listen to his music so loud. The second option is the council could impose a tax on my neighbours stereo which goes into a fund that would compensate me for my loss of utility from home ownership. I could then make a decision which is preferable to make my home more sound proof or to use the money on other things and accept the loss of utility. A third option is that the tax would encourage my neighbour to sound proof his home, avoid the tax and allowing him to enjoy loud music.

Of course, not all music is the same. My neighbour has good taste in music and my dis-utility is not very large. However, I have known people to play Michael Jackson and Celine Dion at excessively loud volumes, in this situation the comparison with living next to a airport would be an inaccurate one, a more accurate comparison would be living next to a toxic waste dump.

Homer Economicus or Homer Sapiens? - Book Review

Jodi N Beggs of Economists Do it With Models has made a significant contribution to Economics education with her lectures on econ101 and microeconomics. Her website along with Tony Cookson's Intromediate Microeconomics was my inspiration in creating this website. So when I saw Beggs had self published a small book on Amazon about Behavioral Economics I felt obliged to purchased the book at the hefty price of .99c.

I should start by saying that before reading this book I had no background in behavioral economics; but had felt that economics needed to move further in the direction of psychology rather than ever more complicated mathematical models. Beggs explains the basic concepts covered by behavioral economics using the characters of the Simpsons. Homer and Bart being the least rational and most "human" of the characters with Marge and Lisa being the voice of reason/rational thought. Topics covered in concepts covered include,

• Time-inconsistency, Procrastination and Commitment Devices,
•  Reference-Dependent Utility, 
• Narrow Bracketing and the Endowment Effect,
•  Bounded Rationality and the problem of Overchoice,
•  Mental Accounting, 
• Transaction Utlilty and the Power of Free,  
• Nudges, Anchoring Framing.    

This little has left me craving more information on this exciting area of economics and it also made me feel that my childhood of Simpson watching was not miss spent. If you want a fun way to learn some basic Behavioral Economics, then for 99c you should buy this book. Seriously, when was the last time you laughed reading a book about economics? 

Iceland - The forgotten country.

I was thinking the other day, whatever happened to Iceland? At the beginning of the global financial crisis Iceland's three banks collapsed leveraged beyond the small nations GDP. Total debt reached  9.553 trillion Icelandic krónur (€50 billion) compared to Iceland's GDP in 2007 of  1.293 trillion krónur (€8.5 billion). Iceland went cap in hand to the IMF, its currency collapsed to about half its previous value compared with the USD. The world for the most part wrote off Iceland and the IMF required a significant austerity package in condition for their support.

So what has been the experience of Iceland since 2008?

GDP Growth: 2008 1.4, 2009 -6.9, 2010 -3.5, 2011 2.2, 2012 2.9.

Unemployment: 2009 7.2%,2010 7.5%, 2011 7.0%, 2012 6.2%, 2013 5.3%

Government Debt (% of GDP): 2008 102%,2009 120%,2010 120.2%

Government Fiscal Condition: 2008, -13.5, 2009 -10.0, 2010 -7.8 (Expected to return to surplus 2013)
(Source OECD, http://www.oecd.org/document/62/0,3746,en_33873108_33873476_45269950_1_1_1_1,00.html)

So what can be learnt from Iceland? First Iceland did not bailout its banks, choosing only to bail out its depositors and not the investors. Second, Iceland has managed to stage a slow recovery despite the ongoing crisis amongst its European neighbors. Thirdly, having a national currency that can respond to crises may help other industries stage a recovering. Large energy intensive investment projects and a residential construction boom has led economic growth. Finally, austerity measures that led to sustainable government debt levels may play a role in supporting the economic recovery.

While I can't claim to know enough about Iceland's unique situation or how it impacts on the sovereign debt crisis. I suspect that there has been little effort to learn any lessons from Iceland and instead the Government's in Europe continue to look for a painless recovery.

The Paul Krugman Drinking Game

In Australia, universities are currently on their summer holidays. This is a time where instead of allowing students to finish their degrees earlier, universities allow their lecturers to do their "real work" without all those pesky students to teach. In the absence of formal education students need to find fun ways of learning more about economics. In response to this need I have created the Paul Krugman drinking game. The rules of the game are simple.

1. First one person is chosen to read articles from Paul Krugman's New York Times blog, the Conscience of a Liberal.
2. Everytime Prof. Krugman refers to one of his own papers or claims to have written about something before anyone else you have a drink.
3. Don't drive home after this game as you will be very drunk.

Just to be fair, to Paul Krugman I have enjoyed reading many of his papers, blog entries and his book return to Depression Era Economics. (Which I will review soon)

Creative Destruction and how it impacts on our lives.

So often in the news we hear of some formerly successful industry going bust. Trade unions and industry groups lobby hard for their industry to be saved through government intervention. A recent example in Australia and globally has been bookstores. I remember my excitement when the first Borders opened in the Brisbane CBD. I could buy a mocha caramel-latte at Gloria Jeans, choose from a range of specialty books that were never offered in Brisbane before. Having an interest in management literature, it wasn't long before a had a large library of business titles and career development books.

Books would cost between $20-30 and textbooks could be up to the cost up $100. Now ten years on, Borders has gone bust and rumor has it that the building will become one of those ghastly Apple stores. Sorry, couldn't resist. This is where creative destruction comes in. The Oxford economic dictionary describes creative destruction as, "A model of economic growth driven by quality-improving innovations that make old technologies or products obsolete."

That pretty much describes my once beloved Borders, obsolete. I now have two new superior ways of buying books, first, Better World Books and second Amazon kindle. For my studies I have only bought one new textbook in 2 years. Others, I have bought secondhand on Better World books. Technology has allowed me to connect with bookstore all over America where slack students have foolishly sold their old textbooks allowing me to buy them for between $10-$20. Amazon Kindle has allowed me to purchase new books at a fraction of the price I would have paid at Borders.

This technological innovation has dramatically increased my consumer surplus. Not only in quantity but in quality. I recently was preparing for a job interview as a Business Analyst and realised I didn't have sufficient skills using Microsoft Excel. In the bad old days, I would have driven to the bookstore, not found a book that really covered what I wanted and would have settled for some more basic book about Excel with a few accounting formulas in it. Instead, I went to the Amazon Kindle store, within five minutes I had a book called Business Analysis in Microsoft Excel 2010. I could read reviews about the book confirming the books quality and ensuring the author handled the topic well. This book covered everything I needed, there would have been almost no chance of me finding such a book in a bookstore in Australia.

From a bookstores point of view had they had such a book it would have sat on their shelf for months waiting for an econ nerd like me to come in, if I had come in at all. The price would have been significantly higher to cover the much higher costs of having that inventory sitting on their bookstores shelf for so long. So technological innovation increased the quantity of products I could choose from and lowered the price. Creative destruction.

Why the minimum wage hurts the poor.

Okay, I'm going to take on very sensitive issue, the minimum wage. The minimum wage is based on the idea of fairness, it sets by law the minimum payrate an employer can pay an employee. I am going to explain why this policy leads to greater unemployment and prevents the poor from entering the labour market increasing their skills.

Below, I have crudely drawn diagrams of the market for low skilled and skilled labour. In any market there is supply and demand. Where these two curves meet is at a price where both the supply and demand are exhausted and the market has cleared. The amount of the good or service supplied is the same as the amount demanded. On the below diagram there is a horizontal line indicating the minimum wage. For skilled labour the market equilibrium E is above the minimum wage and therefore the minimum wage does not affect that market. However, for low skill workers the the minimum wage is above the equilibrium which means there is more supply of labour than demand. This results in unemployment. This situation is good for those low skill workers lucky enough to get a job as they will be paid above market rates, equally it provides a safety net for skilled workers incase they ever need to drop down to low skill work. The losers are those people whose productivity does not justify earning the minimum wage and are excluded from the labour market. These people are the poorest and least educated in our society and as Milton Friedman pointed out in his tv series 'free to choose' it prevents those people without a formal education from gaining training in the workplace by working at a payrate where employers would be interested in hiring them.

I can say from my experience as an employment consultant there are many unseen victims of these industrial policies whose productivity doesn't justified earning $18-$20 an hour. Such people would need a large investment in time an energy by an employer before their productivity would raise to such a point. Fortunately, there are tools to allow employers to train such workers, the traineeship. Unfortunately, the administration of setting up a traineeship prevents this tool from helping more people at the bottom of the labour market.

On a final note, I should point out that there is a decenting view on the traditional view of the minimum wage. Card and Krueger 1993 found that when the minimum rate in New Jersey was raised the employment opportunities increased. I have provided the link so you can decide for yourself. http://www.nber.org/papers/w4509

Great jobs for Economic Majors - Book Review

Having worked in the recruitment/employment services industry for over four years and being a student of economics, I have a unique perspective on this book. Many will find this book disappointing because it doesn't have an overly detailed analysis of the employment market for economic graduates. It does however provide a basic overviews of the areas that employ economic graduates and some areas where the skills of econ majors are highly regarded. Instead this book provides the skills for the reader to analyse their local labour market for themselves and to start being proactive in their jobsearching. I have found over the years that most jobseekers lack these skills and use a very narrow range of methods to job search. When these methods are exhausted the jobseeker often gets frustrated and feels that their studies came at a large opportunity cost with little prospect of pay-off. As a result I would recommend this book for any 2nd-3rd third years students as a way of preparing themselves to do some active job searching.

Bottom Billion - Book Review

I have just finished reading Paul Colliers book the Bottom Billion. http://www.amazon.com/Bottom-Billion-Poorest-Countries-ebook/dp/B000SEIU28/ref=sr_1_2?ie=UTF8&qid=1323505577&sr=8-2 Now at this point this review could easily turn into a sales pitch about how good the kindle app on my android tablet is and how it brings books that would be $30 or more in an Australian store to my tablet for the cost of $9. However, today I will review the book.

Paul Collier is Professor of Economics and Director of the Center for the Study of African Economies at Oxford University and a former director of Development Research at the World Bank. However, this book is not only for economist or economic students this book explains the economics of development to the non-economist.

The Bottom Billion are a group of nations many of which are in Africa which are the poorest nations on earth. This book is not about the problems in middle income countries or emerging Asia. The bottom billion are countries which have seen little or no improvement in their GDP per Capita since the 1970s. They are often landlocked, caught in the trap of civil wars and coups. Many of these nations are resource rich which he explains is often more a curse than a blessing. Collier makes a compelling case about ways these nations can improve their institutions and what we in the West can do to support them.

Having recently written a report on the progress in the United Nations Millennium goals I became aware that most of the progress in alleviating poverty has occurred in Asia. Colliers book supports this view that while much of the world's population has a realistic prospect of reaching middle income status by the middle of the century, there are nations which make up about a billion where no progress has been made and little sign that is going to change.

Collier's views have been formed by years working in the field of development and are inline with standard economic theory. What this book is not, is a cheering squad for free market economics and the Washington consensus highlighting the unique problems faced by the bottom billions. For example, Collier explains that it will take several decades before there is a significant wage gap between Asia and the Bottom Billion. Although wages are cheaper in Africa than in Asia, the expense of doing business in Africa due to the lack of infrastructure, human capital and reliable institutions means there is little prospect of Asia moving to higher skilled manufacturing and low skill manufacturing establishing in the Bottom Billion.

Equally, this book will not become the manifesto of the No Logo anti globalisation movement. Collier's views are not anti-trade and outline ways in which the West can increase trade with the Bottom Billion. Collier also argues the case for military intervention, a view never popular with the left. He is also critical of the Fair Trade Movement and large charities that sell t-shirts based on anti-globalisation advertising campaigns.

I would recommend this book to anyone with an interest in economic development and is interested in a practical ways of address global poverty rather than lazy ideologies. I have provided a link to a speech by Paul Collier. http://www.youtube.com/watch?v=iXTFuqJ-Hgs

The problem of information quality for online sales.

This week Bush Telegraph on the ABC reported, that the department of Primary Industry in NSW is attributing an increase in incidents of foot rot in livestock to online sales raising concerns about the reliability of information provided on online auction websites.Traditionally, livestock have purchased at sales yards where buyers and sellers meet and the buyer can inspect the animals they are considering purchasing. However, online this is not an option and the buyer is dependent on the integrity of the seller. It would make sense that a decrease in the buyers ability to cheaply acquire quality information on the livestock they are purchasing would result in an increased asymmetric information problem. The seller knows far more than the buyer about the animals being traded, this is always the case, however traditionally the buyer can take measures reasonably cheaply to increase information before sale.

This problem of of asymmetric information can be seen with most online sales. Many sellers knowing they have an increased advantage over the buyer take advantage of this and sell inferior goods as seems to be occurring with livestock and happens daily on ebay where no genuine or poor quality products are sold with claims of the product being high quality. The result of this deception is that the term high quality or genuine no longer attracts a higher price in the marketplace with buyers assuming that all products are of a low quality.

Sellers who have a high quality item to sell have several options, they can offer warranties on their goods. They can also provide increased information. In the example of livestock the auction site allow sellers to provide reports by registered veterinarians. Another example is ratings systems that appear on ebay and amazon. Such systems allow sellers to read reviews by previous buyers and can make a decision on the past experiences of other people. Ultimately, auction sites may never be able to guarantee quality information to the same degree that a trusted retailer can. Previously, I have purchased a "genuine" watch which came in authentic looking packaging, is fully functional has a certificate of authentication and was one fourth the price I could have purchased locally. In spite of the information provided I believe my purchase was not genuine Swiss watch and I would never be 100% certain any watch purchased on ebay is genuine. I am sure, I am not alone in this believe and therefore consumers on ebay are likely to assume all watches are fake and as a result genuine sellers of swiss watches will either have accept a low price for their watch or find another marketplace. As a result the seller of both watches and livestock are faced with a choice either to increase information available to buyers or to accept lower prices. 

The problem with foreign aid.

Recently delegates from OECD nations meet to discuss Aid effectiveness at the 4th Annual Aid Effectiveness Forum. As a result I thought this was the perfect time to discuss some of issues with foreign aid and the impact those problems have on development. Many of you will be aware that in the year 2000 world leaders met at the United Nations and agreed as part of the Millenniums Development Goals to rise foreign aid to 0.7% of GDP. Since then we have had the make poverty history campaign and many campaigns by individual NGOs to achieve this goal. At present only four nations look likely to honour this agreement and they are the usual suspects Sweden, Denmark, Norway and another country I can't remember.

Before discussing the merits of the millenium goals and their possible impact it's important to discuss the history foreign aid. Foreign aid began it's life after the second world war. Europe and Japan were destroyed and the Soviet Union looked poised to expand its empire. The United States fearing the lose of Europe to communism pledged to rebuild Europe. Their answer was the Marshall Plan, America financed the rebuilding of Europe and by the 1960s you had the German Miracle. In the Pacific, foreign aid from America and the benefits of being the launching pad for the Korean War meant Japan was rebuilt and by the 1970s was rapidly catching up to west in economic development. Out of this period came the IMF and the World Bank. Both these institutions worked helping the war destroyed nations rapidly grow their economies until they plateaued at about 75% of the GDP per capita of the United States.

Another consideration is that there has not been a significant example of foreign aid helping nations escape poverty since the rebuilding of Europe and Japan. A major reason for this was, foreign aid for most of the post war period served an anti-communist purpose rather than a development role until the fall of the Berlin Wall. Secondly, Europe and I would argue Japan were already developed nations. All Europe and Japan needed were funds to replace the capital they previously had. These countries had institutions, they had the human capital to utilise the aid. In Low Income Countries today these conditions don't exist and when we are talking about foreign aid we mean low income countries. Middle income countries like many nations in South East Asia, Eastern Europe or South America can access funds through the capital market and do so.

So far I have already addressed one problem with foreign aid which is the lack of human capital, often developing nations don't have the expertise to utilise foreign aid effectively. As result, developing nations receive technical assistance as well as money from institutions such as the World Bank. The difficulty with this, is it can often be seen a measure of inefficiency and leaves the institutions or nations providing foreign aid open to claims that funds are used to pay high wage earning advisers rather than helping poor.

Another problem is the lack institutions in developing countries, its very difficult to get statistics on the amount of foreign aid that gets spent of the military or is lost through corruption. Obviously, the nations receiving aid have little incentive to make that information available or be open about the fact that foreign allows them to spend fund collected through domestic taxation on things such as the military.

Thirdly, foreign can actually have a dutch disease effect, in that in that in can drive up a nations exchange rate making low skill labour intensive manufacturing (the usual pathway to middle income status) uncompetitive. Obviously, this is an unforseen side effect and needs to be considered. Strategies need to be in place to shield the exchange rate from the effects of the foreign capital.

I don't see any of these three points as arguments against providing foreign aid but they need considered and people who think that ending poverty is a simple matter of transfers from the developed nations to the developing need to wake up and realise that the transfer model only worked because everything was already in place in Europe. The other example of economic development was mostly achieve not by foreign aid but through participation in global trade. In a future post I will visit the history of the rise of the Asian Tigers. Careful and considered foreign aid may have role in developing human and institutional capital in the low income countries to help them become the next Asian Tigers.