Wednesday, July 23, 2008

Fiscal Drag and the $8000 ceiling

Fiscal drag is one of those things that you never read about except in economics textbooks.

It refers to one of the pernicious effects of inflation. As the nominal income of a person increases due to wage demands that stem from inflation, a larger proportion of that person’s income goes into the next higher tax bracket, and is taxed at a higher marginal rate of tax. Hence, the real income of a person takes two hits: the first hit from nominal wage increases not keeping pace with inflation, and a second hit from a higher tax burden resulting from fiscal drag.

I am sensing the (minor) effects of fiscal drag as I keep careful records of my own income. The effect is minor because, well, engineers really are one of the least well-paid professionals around.

Fiscal drag is one symptom of a wider malaise that can be termed institutional sluggishness. Basically, this refers to the phenomenon whereby legislation is written in nominal rather than inflation-adjusted terms. Fines for instance, do not get adjusted upwards in line with inflation, although I don’t think anyone is complaining about that.

What people have been complaining about recently is the $8000 monthly salary ceiling for buying a new flat directly from HDB and for households to be eligible for a HDB loan. Now that is one example of institutional sluggishness par excellence.

[Normally, I wouldn’t care enough to write about this as I am single and currently have no plans to marry. But talk among my friends and colleagues about the $8000 ceiling and recent musings on inflation piqued my interest enough to want to post something on this.]

You could make a case that real income actually has risen in recent years due to the economic boom, so the $8000 ceiling should still stand to reserve public funds for the less well-off. But we are now entering an inflationary phase and wage increases (at least among professionals) are reflecting that. I have seen my own nominal wage increment this past year higher than in previous years, but I’m astute enough to realize that in real terms, my wages have actually diminished.

So, given that nominal wages have increased but real wages have fallen, why hasn’t the $8000 salary ceiling been revised upward, especially since so many young couples are hurting from high property prices?

The government could revise this figure rapidly if it wanted to. Indeed, when there is legislative need, the government has shown that it can move at lightning speed, compared to the glacial pace of other governments worldwide. So why hasn’t it this time round?

I don’t think the government is ignorant of this issue. The most probable explanation for not revising the $8000 ceiling upwards is that the income ceiling applies to a relatively small group of people (albeit a more educated and vocal group) and the government doesn't view the income ceiling as a major problem. And as mentioned above, a working couple that makes >$8000 per month is hardly destitute. The new "subsidised" flats and cheap HDB loan are arguably a privilege and not a birthright. After all, singles and permanent residents are not entitled to these perks.

But this explanation isn't very interesting [otherwise I wouldn't be blogging on the topic]. I have an alternative hypothesis, although I caution that this is more a thought experiment on my part rather than a concrete assertion.

My hypothesis is that while this problem has been brought about by the current inflationary environment, the government has consciously chosen not to revise the $8000 salary ceiling precisely because it is fighting inflation.

Inflation is composed of demand-pull and cost-push inflation. A bad analogy for this would be good and bad cholesterol. It would be more accurate however, to say that demand-pull inflation, while still bad, is generally symptomatic of buoyant economic conditions, and so is usually perceived in a better light than cost-push inflation. Cost-push inflation is just plain ugly.

Not revising the $8000 ceiling upwards while so many young couples are crying out for it has the salutary effect of curbing demand for real estate, and hence cooling the formerly red-hot property market. As mentioned in a previous post, property prices are a component of the Consumer Price Index. The net result is a lowering in the housing component of the CPI due to a fall in demand-pull inflation within the real estate sector.

The government, like most governments, can do very little to curb cost-push inflation, although you are unlikely to read about that in the mainstream media [taking credit, even for chance events, always gets published; admitting powerlessness over problems, never]. Beyond allowing our domestic currency to appreciate (up to the point when exports really start to hurt) and urging Singaporeans to conserve, our government's hands are tied.

So, while it can’t do much about cost-push inflation, it can reduce demand-pull inflation as mentioned above, at least in the property sector. Taken together, this has the effect of moderating the rise in headline inflation (the CPI). This is helpful as it reduces inflation expectations among the populace.

It’s not clear whether revising the $8000 salary ceiling or not is the ‘right’ thing to do. I won’t venture to make a value judgment on this.

I do empathize with young couples though. Assuming my thought experiment is correct, it is never easy to receive the short end of the stick in the government’s interest of ‘the big picture’. On the plus side, the government is increasing the supply of HDB flats, so hopefully that should make property more affordable.

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