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Economic Review

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1997 Quarter 1 | Vol. 33, No. 1


The Welfare Loss from a Capital Income Tax
by Jinyong Cai and Jagadeesh Gokhale

A capital income tax distorts consumer choices along two margins: the intertemporal margin (consuming today versus tomorrow) and the within-period, or "static," margin (consuming durable versus nondurable goods). The static distortion, which the literature has largely ignored, emerges because the income tax base excludes service flows of durable goods. This article decomposes the welfare loss from a capital income tax into its static and intertemporal components. Calculations using a calibrated life-cycle model with a representative consumer suggest that ignoring the static distortion may lead to substantial underestimation of the total welfare loss from a capital income tax. This finding implies that if ending capital income taxation is not feasible because of equity or other considerations, the static excess burden may be eliminated by taxing the purchase of durable goods.

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Tax Structure and Welfare
by Jang-Ting Guo and Kevin J. Lansing

This article examines the welfare implications of some basic structural features of the U.S. tax code. The authors consider the tax deductibility of depreciation and the practice of taxing labor income differently than capital income. Their results show that long-run welfare and output can be improved by a policy of "accelerated depreciation," whereby the depreciation rate for tax purposes exceeds the rate of economic depreciation. This policy increases the tax on pure profits relative to other types of capital income. The authors also find that the benefits of applying separate tax rates to labor and capital income tend to be minimal over a range of typical depreciation tax policies.

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1997 Quarter 2 | Vol. 33, No. 2



The Recent Ascent of Stock Prices: Can It Be Explained by Earnings Growth or Other Fundamentals?
by John B. Carlson and Kevin H. Sargent

The U.S. economy has enjoyed a long, healthy expansion in the 1990s. Inflation has been contained, and there is little evidence of any imbalance to suggest that the end of the upturn is imminent. Earnings growth during this period has been extraordinary. If investors expect a small component of the recent surge in earnings to persist indefinitely, then stock prices would be higher than traditional valuation approaches indicate. The analysis presented here, however, suggests that earnings growth is not the whole story.

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Workforce Composition and Earnings Inequality
by Mark E. Schweitzer

The widening disparity in Americans’ earnings has resulted from many factors—including education, experience, and industry choice—that combine to yield wage dispersion. Earnings can also vary substantially among demographic groups. Identifying the sources of this growing inequality requires a model that incorporates many earnings factors simultaneously in order to account for covariation: Commonly applied subgroup decompositions often over- or underestimate the role of a single factor of interest. In this article, the author uses a decomposition that accounts for covariation among several factors and demographic groups. His main finding—that the shifting composition of the U.S. workforce is a significant and direct determinant of the widening earnings gap—suggests that policy prescriptions which ignore this striking change may take a long time to work.

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The Risk Effects of Bank Acquisitions
by Ben Craig and João Cabral dos Santos

Between 1981 and 1994, there were 6,167 bank mergers and acquisi- tions in the United States. Some of the motives behind this consolidation trend, including scale economies, scope economies, and managerial X-efficiencies, have been studied extensively. Other frequently mentioned motives, especially risk diversification and the desire to become "too big to fail," have received less attention. This article examines the risk effects of bank acquisitions that occurred between the first quarter of 1984 and the last quarter of 1993. Its primary findings—banks are not using acquisitions to increase their risk exposure (and thus their deposit insurance subsidy), and acquisitions have a positive impact on profitability that increases over time—raise doubts about the importance of risk diversification as a motive for bank acquisitions.

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1997 Quarter 3 | Vol. 33, No. 3



Recent U.S. Intervention: Is Less More?
by Owen F. Humpage

This article investigates the forecast value of U.S. interventions in the foreign exchange market, which have become increasingly rare in the last seven years. Evidence of superior forecasting skill would imply that U.S. monetary authorities typically act with better information than the market and that intervention could alter foreign exchange traders' expectations about rates. However, the analysis presented here shows that this was not the case for recent interventions (May 1, 1990-March 19, 1997), and that official transactions by U.S. monetary authorities do not seem to improve the efficiency with which the foreign exchange market obtains information.

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Inventories and the Business Cycle: An Overview
by Terry J. Fitzgerald

The literature on business inventory investment provides a good example of how theory and data interact in the ongoing process of research. This review of work on the relationship between inventory investment and business cycle fluctuations focuses on the developments of the last 15 years, a period characterized by renewed interest in the role that inventories play in the aggregate economy. A central issue underlying the literature is the relative importance of demand and supply shocks as sources of business cycle fluctuations-a question that continues to be debated today.

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The Long-run Demand for Labor in the Banking Industry
by Ben Craig

Until the last decade, U.S. banks were considered nearly impervious to the employment swings that affect most other industries. Between 1989 and 1995, however, banking payrolls shrunk more than 6 percent, while U.S. employment and the overall labor force experienced a steady expansion. Equally interesting is the fact that the loss of banking jobs occurred as aggregate output in the industry rose 15 percent in real terms. This article uses call report data to examine two often-mentioned reasons for the decline in banking employment-new technology and industrywide consolidation-and finds that technical change explains the downturn only for large banks, and that acquisition accounts for very little of the overall employment change.

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1997 Quarter 4 | Vol. 33, No. 4



Generational Accounts for the United States: An Update
by Jagadeesh Gokhale, Benjamin R. Page, and John R. Sturrock

Although the generational stance of U.S. fiscal policy has improved considerably over the last two years, it remains substantially imbalanced and is unsustainable. If living generations’ continue to be treated as they are under current policy, future generations will have to pay almost half of their lifetime labor incomes in net taxes to balance the government’s books. This is more than 70 percent larger than the 28.6 percent today’s newborns are slated to give up. In this article, the authors look at what it would take to restore a generationally balanced fiscal policy. The possible solutions include an immediate and permanent income tax hike of 20 percent, a 19 percent cut in transfer payments, or a 15 percent reduction in government purchases. These measures may seem harsh, but waiting to act will make the task even more difficult.

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Does Intervention Explain the Forward Discount Puzzle?
by William P. Osterberg

This article uses official 1985-91 intervention data to investigate the impact of U.S. and German central-bank interventions on the forward discount puzzle for two exchange rates-the German mark/U.S. dollar and the Japanese yen/U.S. dollar. Evidence on the importance of intervention is strongest for the mark/dollar exchange rate. However, whereas Flood and Rose (1996) found that the puzzle was stronger for floating than for fixed exchange-rate regimes, this study finds it to be stronger during periods of intervention than at other times. Thus, if intervention is associated with fixed-rate regimes, the results reported here are inconsistent with those of Flood and Rose.

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