The sticky mess we’re in?

The quality of Canada’s new and existing jobs is slipping, concludes CIBC economist Benjamin Tal after calculating the latest Job Quality Index (JQI), which is based on compensation (70% of the index) and job stability. Tal suggests that the JQI is slipping because self-employment is rising (not necessarily a bad thing if it’s encouraging workers into the labour force who had previously outsiders) and/or unskilled workers are being used as substitutes for skilled workers because Canadians lack the right skills.

Perhaps an interesting statistic would be the relative "stickiness" of the JQI over time. To the extent that we can expect bad jobs to replace good jobs more quickly than vice versa, stickiness may be somewhat predictable, depending whether the index is rising or falling. But if the JQI quickly rebounds after falling, and if we know which components caused the JQI to fall, this may be telling.

For example, consider scenario A and B in period of time (t), both of which take the JQI to the same level below JQI (t-1). In scenario A there’s weak compensation due in large part to an increase in self employment spurred by individuals inside and outside of the labour market. There’s also weak stability because an increase in jobs in western Canada draws workers (again, from within and outside of the labour market) west to try on jobs until they find a satisfactory match.

In scenario B the situation is similar, only now the greatest weight pulling down the JQI is unskilled workers being used as substitutes for skilled workers when in actuality they are not substitutes. Again, consider that JQI at B is at par with JQI at A.

Would either scenario have a stickier JQI? The significance has to do with our productivity and our ability to rebound from a recession. In scenario A we have a weakish economy but more people in the labour market. In scenario B we have a weakish economy and evidence of more of a mis-matched, unskilled labour market. If we can agree that we're seeing a mix of scenario A and B, perhaps the [edit: greater ] A is, the less sticky we can expect the JQI to be. To be clearer, studies have shown, for example, that "a lack of employment stability, job skills, and occupation-specific experience can impede welfare recipients’ abilities to obtain “good jobs” or transition into them from bad ones."

On a side note, overall I like CIBC's’s JQI as a raw estimate. It has its weaknesses (no pun intended); for example, it's based only on compensation and job stability. However, it also avoids mistakes made by others (eg, CIBC uses data from 100 separate industries, rather than data from industry aggregates).

Productivity and firm size in construction, pt2

A couple of posts back I asked why Canada’s construction sector is said to be more productive than the U.S. sector, despite having smaller establishment sizes. The gap isn’t huge, but it’s surprising. I don’t know if any single concept can answer this. Instead, I’ve broken it down to two questions: why are the Canadian firms small, and why are they more productive.

On being small…

Small establishments are unburdened from taxes on inventory
If one considers the high taxes that the construction sector faces on inventory, it seems reasonable that large companies wish to unburden themselves of this tax by contracting individuals to do certain services. Perhaps in Canada self employed contractors are more willing to take on the risk of being taxed on inventory (perhaps due to favourable tax scheme on Canada’s self employed, in comparison to the U.S.? I don’t know if this would justify the gap).

Variable taxes, in contrast to flat taxes, keep establishments small, even in Canada’s most populated areas where construction productivity is destined to be highest regardless of establishment size
B.C. has the lowest provincial tax rate in Canada up to a taxable income of $67,500 per annum. Above this income level, the rate rises rapidly and Alberta becomes the lowest personal tax jurisdiction at an income of $88,000 per annum. B.C. has the highest unincorporated self employment rate of all of Canada in the construction sector while Alberta has the highest incorporated self employment rate (see graphics below that I created using StatsCan CANSIM data Table282-0011). Perhaps Canadians are more sensitive to an un-level tax scheme than Americans.

Here's my colour scheme:
self employed unincorporated w/ no paid help,
self employed incorporated w/ paid help,
self employed incorporated w/ no paid help,
and the final pie in lime is self employed unincorporated with paid help.

On being more productive…

Economies of scale are relatively unimportant in the construction sector
Construction is highly labour-intensive, depends on a high proportion of low-skilled jobs and is not considered a high technology sector. Further, I would argue that where economies of scale do matter in the construction sector, they mean less than they once did. Thus, simply being big doesn’t give U.S. firms a greater advantage in this sector.

And yet this isn’t the case with other labour intensive industries. The U.S./Canada "productivity gap is large in other labour intensive industries such as textiles and clothing as well as in fabricated metals, the machinery and computers industry, and the electronic and electrical equipment industry." So maybe this idea is a dud.

The hidden economy
If labour inputs are somehow being underestimated, then productivity (measured in my last post as GDP divided by hours worked, by the way) could be distorted.

For example, John O’Grady (2001) estimated that, on average, the annual underground income in Ontario’s construction industry, in the period 1998-2000 increased to $2.395 billion. This is due to the "hidden economy" composed of self-employed individuals who wish to conceal their income, which we know is easier to do in the construction sector than nearly any other sector.

Also, I think dachisb made a good point in response to my first post: "I would wager that low cost labour (read mexican migrants) drives most of this difference."

Not all construction is made equal
I’m not sure what affect this would have, but I thought it was worth noting that heavy and civil engineer construction is much smaller in Canada then, say, the construction of buildings. Surely many modes of construction have their own unique productivity level, and the compilation differs across countries.

Am I missing anything? Any more ideas anyone?

The rise of necessity entrepreneurs?

December saw 62,000 new jobs, taking the jobless rate to a 30-year low.

Ahem. Who was it that defied just about every analyst that said the labour market would fall in Q4? I believe it was me. But perhaps I was just lucky. Anyway, I didn’t see it all coming...

Self employment is booming. BMO economist Douglas Porter says December’s job gains were spread across all sectors, except construction was up only slightly. Is there any good reason why all these people with jobs wouldn’t pump up residential construction? Perhaps, if they didn’t have the right jobs. The Globe and Mail reported today that 49,000 of the positions were characterized as self employed.

This reminds me of a previous post where I explored three reasons why individuals might become self employed:

a) self employment is a stepping stone to other work

b) self employment is a stepping stone to retirement

c) self employment persists in periods of poor job growth

As hiring slows down, it might be the case that a) and c) are coming true. Perhaps self employment really is an innate survival skill. I’ll return to this topic at some point.

Also, I haven’t forgotten about my last post on the construction sector. I’ll continue with that tomorrow. Or something.

Productivity and firm size in construction

Why would Canada's construction sector be more productive than the U.S. sector despite having smaller establishment sizes (ie. fewer employees in each establishment)?

If it’s the case that American construction firms, for whatever reason, have a greater ability/willingness to take advantage of economies of scale (an explanation for their larger establishment sizes), one might expect the U.S. construction sector to be more productive than Canada’s. Empirical evidence suggests otherwise. Canada’s construction sector, despite its smaller establishment sizes, is more productive, says several studies. It also has slightly more capital intensity, but this could mean a few things (ie. low economies of scale; high capital costs).

I have some ideas but I'll sit on this some more and come back to it in my next post.

Source of graphs: Don Drummond, TD economist (2005).

Tax evasion: lessons from Egypt

In my view, we should be taking a lesson from Egypt when it comes to dealing with tax evasion. I'll explain.

Studies claim that tax evasion among the self employed in Canada is common and the costs are high. What should be done? First, it depends if the government is concerned purely with inefficiency, or if its concern is inequality (which do not need to be trade-offs, as I've argued before here; and I'll point to my view on equality here). I'm going to address the aim of efficiency here, but I'll quickly explain why.

In a welfare state, the objective of an inequality-averse government would be to raise taxes to redistribute incomes, and thus auditing would be useful to protect the tax base. But there are drawbacks to making equality the only major priority. I won't get into the old equality debate again here, but here are a few thoughts: First, when are degrees of inequality aversion sufficient? And, how do we know if such a degree is attainable? Finally, it's worth repeating that, if efficiency is gained, equality does not need to be a trade-off.

My assumption henceforth is that efficiency is the government's concern when it comes to deterring tax evasion.

What actions can the government undertake to increase efficiency? Three possibilities: Do nothing, design an efficient auditing scheme, or cut taxes to a point where the self employed are more willing to pay (and, ultimately, adopt a low flat tax).

Do nothing

If efficiency is the major concern, nothing should be done, claims Simon C. Parker in The Economics of Self Employment and Entrepreneurship (2004: p. 248). Audits are expensive for the government and for the individuals who prepare the tax reports for audits. [edit: My hurried fingers pasted the wrong quote here. Sorry. Intended quote:] "These costs impose deadweight losses on the economy." Parker concludes that a government would be more efficient to not audit.

Design an efficient auditing scheme

Herb J. Schuetze (2002) disagrees. He finds that (at least in Canada) a discriminatory method of auditing would be most effective in reducing tax evasion.

Excerpt from Schuetze's paper "Profiles of Noncompliance Among the Self Employed" (2002, p 19-20) (The entire paper can be found here. Click on "research"):

Even though pre-tax wages will adjust to equalize after-tax wages, too many resources, in terms of efficiency, will be allocated to occupations which provide the greatest opportunities for noncompliance. This result also suggests an obvious strategy for the development of an effective tax audit system. One which targets the self-employed in construction and service occupations is likely to be more effective.

...A tax audit scheme targeting groups which have been found to conceal income the most (such as self employed households headed by younger males or those in the construction and service occupations) is likely to be an effective tool in reducing noncompliance.

He acknowledges a disadvantage:

Clearly, such a policy, if continued for a period of time, would lead to the misrepresentation of occupation and other characteristics by self-employed tax filers to avoid being audited. However, if the information from these audits is used effectively, policies can be designed to reduce noncompliance.

Such a well-designed auditing scheme might be attractive, but perhaps its major disadvantage (other than the one pointed out by Schuetze) is that it's not simplistic. Simplicity in self-employed tax treatment, or any tax treatment for that matter, should be an objective within any economy. By the way, The World Bank agrees with this sentiment (link via The Heritage Foundation) :

Complicated tax systems can lead to high evasion, even when rates are low. ... A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate.

Lower taxes

In my mind, the best solution would be to take a lesson from Egypt. That is, lower taxes to a point where the self employed are willing to pay (zero would be the ultimate). By extension, if taxes for the self employed are to be lower, taxes for all business should be lower. A flat tax seems to be the most efficient, but I digress. Let's get back to Egypt.

Excerpt from "TAX: Abrupt halt to haggling." The Financial Times, Dec. 11:

"The existing culture as far as the tax authority was concerned was a story of predation." says Youssef Boutros Ghali, the finance minister. "Anything the tax authority could squeeze out, it did. But now we have affected a fundamental change of attitude. We have given up predation and established a partnership through a law that is transparent rather than fuzzy and through reducing the tax rate to what people would be willing to part with."

The new law set the top rate at 20 per cent for both individuals and companies, down from 42 per cent. It offered a total amnesty to those who had never filed a return in their lives, regardless of how long they had been earning, if they presented themselves before the end of March 2006.

The law also introduced self-assessment, changing at one fell swoop a system based on the assumption that the tax payer is always a liar, to one in which inspectors have to believe properly-maintained records presented to them, unless they can come up with evidence of wrongdoing.

At the same time penalties for tax evasion have been seriously stiffened. Mr Boutros Ghali says the impact in the first year has been dramatic, with 2.6m returns filed, up from 1.7m in 2005.

The finance ministry had been expecting receipts to drop by 12 per cent in the first year and by 7 per cent in the second before climbing back to their original level at the time the legislation was introduced. Instead, tax receipts have grown by 17 per cent - a reflection of both the wider tax base, and the buoyant economy.

....It is still not uncommon for middle class professionals to argue privately that they should not pay tax, citing examples of official corruption or waste, or to justify tax
evasion by saying that they make no use of the subsidized and generally bad health and education services provided by the government and that, instead, they pay exorbitant fees at private schools and hospitals.

Tax inspectors also say that under-reporting is still rife. One cited the example of a doctor who charged him personally $20 when he went for a consultation, but when he filed his return he listed his fee as less than $4.

No one has any doubts that it will take years for a new tax culture to take roots. But there is agreement that new law is definitely a start.

Now Mr Boutros Ghali says that, with an improved computerised system, and freed of the necessity to check the records of every single taxpayer, his 39,000 inspectors will have more time to chase evaders.

Perhaps we could do better to take our complex tax systems to the trash and keep an eye on Egypt.

Income Splitting Among the Self-Employed

Which system of taxation on the self employed evokes the greatest tax distortions?

I) An income-splitting system where individuals may appeal to tax non-compliance; or,

II) A system of individual taxation where individuals may simply not report income.

In an interesting paper forthcoming in The Canadian Journal of Economics, University of Victoria professor Herbert J. Schuetze estimates (with a few caveats) that in Canada’s income-splitting system “…approximately one half of a billion dollars in taxes were avoided in 1998 by more than 90,000 businesses.”

An abstract from “Income Splitting Among the Self-Employed:”

Whether the individual or the household should be the unit of taxation is a long-running debate in the economics literature. One potentially important cost associated with a switch to individual taxation, which has been overlooked in this debate, is the impact of such a move on tax non-compliance. In particular, under individual taxation with progressive marginal tax rates households in which the distribution of income among household members is unequal benefit from attributing income from the higher to thelower income household member. The absence of a third party reporting income enables self-employed households to "split" income among family members to reduce income tax liabilities. Using the Canadian experience as a case study this paper sheds light on the magnitude and nature of this activity by developing a unique estimator of the incidence of illegal income splitting among couples. These estimates provide evidence that the occurrence of income splitting is likely non-trivial and suggest that the costs associated with this activity are potentially significant.

Schuetze draws a comparison between the U.S. and Canada. “The current US tax code, which primarily treats the household as the unit of observation, is such that the distribution of income within the household does not affect household tax liabilities.”

His findings:

…the raw reported employment rates of wives of self-employed men in Canada are significantly higher than those of their US counterparts. …. No significant difference in employment rates are observed among husbands…. I find strong supporting evidence that the employment differential found among wives is indicative of Canadian self-employed men attributing income to their wives.

He concludes:

…the pattern of income splitting found above suggest that countries that have high marginal tax rates, unequal wages across men and women and high rates of self-employment may find a system of joint taxation optimal, while for those with low incentives for income splitting individual taxation may be more appropriate.

Perhaps as equally interesting as his findings (at least to me) is the methodology he uses. He attempts to identify hidden behaviours, taking a lesson from Duggan and Levitt (corruption in wrestling) and Jacob and Levitt (cheating among teachers), among others.

Self employment: an 'innate survival skill'?

Nobel Peace Prize Laureate Muhammad Yunus, Yale's Dr. Robert J. Shiller and others blew me away last week when I heard them speak on microcredit and financial innovation. My perception of poverty in developing countries has bloomed. One thing that struck me in particular from their lectures was the reoccurring theme of self employment.

It's often been repeated that one of the virtues of microcredit is that it's a 'hand up', not a 'hand out.' Essentially, the Grameen Bank offers loans to would-be entrepreneurs, or entrepreneurs who need a supportive push.

The Grameen solution: “...jump-starting self employment, providing the capital for poor women to use their innate ‘survival skills’ to pull themselves out of poverty” (Neff).

Innate survival skills. I like that. This survival concept surely isn't restricted to developing countries. At the risk of sounding like a monomaniac, I'll point out one last time that in periods of recession and poor job growth in Canada, self employment rises. More precisely, low productivity, unincorporated self employment rises.

So why then do we categorize all self employed individuals similarly? Why not group them in the same spirit of methodology that labour economist's use to draw a distinction between economic refugees (those who migrate for jobs), and war refugees (those who arrive only to flee from war and thus have a relatively lower likelihood of perseverance -- ie. if they are met with opportunities or choices which provide them a higher utility level, say, returning home after a war, they'll take it).

My new terminology (subject to change as brighter ideas hit me):

'Economic' entrepreneurs: individuals whose decision to enter business may be influenced by such things as taxes, IT, geography, etc. Such individuals demonstrate the self interest motive at work in the market place and are valued in developed countries.

'Spurious' entrepreneurs: individuals whose drive to be self employed is manufactured by recession or poverty. They tend to depend on heuristic means; they may have little business know-how. Further, after hearing Dr. Shiller speak I would also add (although this is not his idea) that these individuals don't tend to be lured by the profit motive to the extent that economic entrepreneurs are. Tax structures, for example, have little influence on them. Thus, market inefficiencies increase, ceteris paribus, as the ratio of spurious entrepreneurs to economic entrepreneurs increases.

While 'spurious' entrepreneurs offer promise in developing countries, we tend to ignore their potential in Canada because we see the market inefficiencies and low productivity that a high spurious-to-economic entrepreneurship ratio creates. Although, the ratio seems to be declining since the late 1990's and Canada's self employed are doing increasingly well.

I know, I know. It's awfully perverse of me to have absorbed the wisdom of Messrs. Yunus and Shiller with only my self styled ideas to show for it on this blog. For the record, both are doing amazing work and are having a profound impact on people all over the world.

For Dr. Shiller the proof is in the pudding. See here, and here for an interesting read on behavioural finance (Oh, D.R., I've crawled from my rock and I see that you really are on to something good with behavioural economics!).

For Dr. Yunus, the proof is in The Prize. See here and here (in the latter link he suggests that the term 'do-gooders' be replaced with 'social entrepreneurs').

Addendum:

More terminology:

Terms used by GEM (h/t D.R.): opportunity entre­preneurs, necessity entrepreneurs.

Terms used by CIBC economist Benjamin Tal: seniorpreneurs, lifestylers, superachievers

Patterns in self employment

Addendum II: Et voila! Not only is this graph clearer, but it contains more data. (Thank you Ms. D.L.! I knew blogging would pay off!)

Addendum: I'm looking at this graph from a computer with less resolution than my own and it's fuzzier than I observed earlier. Double the apology! I'll have a clearer graph to post here in the coming days.

Many people dream of being their own boss, but is this why Canadians become self employed?

Some other possible reasons that have been theorized:
a) self employment is a stepping stone to other work
b) self employment is a stepping stone to retirement
c) self employment persists in periods of poor job growth

I produced the graph here using data from Stats Canada's Labour Force Survey. Clicking on the graph will take you to the raw data ($ or affiliation req'd). Sorry for the poor quality, but I'll have to leave it for now and learn my lesson for next time.

I was hoping that periods of recession would be observable, but no such luck.

One interesting observation is that the gap between the per cent of the total self employed and the nonfarming self employed (both unincorporated) is closing. I'm missing a stream of data prior to 1987, but when I plotted data calculated in accordance with the System of National Accounts, the pattern looked similar (with smaller percentile values) and it illustrated a progressively shrinking gap from 1976 to 1987 and onwards.

Notice also that the per cent of total unemployed bottoms out during Canada's great boom beginning in 1987. This is inconsistent with other booms though. Perhaps other factors are at play.

Nothing too exciting here I guess. Sorry for the lack of posts. School has been keeping me busy and uncreative.