Interest Rates, Welfare Economics, Public

Interest Rates, Welfare Economics, Public Choice Theory and Taxation Policy

Interest rates

According to the Santa Cruz Community Credit Union, the current (as of June 1, 2005) interest rate on a loan to a successful small business, for an amount between $5,000 and $500,000, for a term of between one and five years, would likely range between Prime plus one percent and Prime plus six percent, with a floor of eight percent. The exact rate would depend upon the credit-worthiness of the borrower. This rate is extremely attractive to business owners. The cost of money is at historically low rates. If a business can expect a ten percent return on their investment, borrowing money at eight percent is a wise move.

The interest rate charged to a successful small business is made of several other rates. The base is the federal funds rate, which is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight. The nominal rate is a target set by the governors of the Federal Reserve. The effective rate is a weighted average of the reported rates at different points of the day's trading occurring through New York brokers.

On top of this is the prime rate, which is the interest rate charged by lenders to borrowers who they consider most creditworthy. It varies little among banks, and banks generally make adjustments at the same time, although this does not happen with great frequency. In general, the prime rate is 3% above the Federal Funds Rate. Unlike other indexed rates, the prime rate does not change on a regular basis; rather, it changes whenever banks need to alter the rates at which borrowers obtain funds. The Wall Street Journal defines the prime rate as "The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks." It has been speculated though that this is no longer the real definition, and that the prime rate is simply the fed funds target rate + 3, because most corporate loans are indexed to LIBOR.

Welfare Economics

Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomics and the income distribution consequences associated with it. It attempts to maximize the level of social welfare by examining the economic activities of the individuals that comprise society. Welfare economics is concerned with the welfare of individuals, as opposed to groups, communities, or societies because it assumes that the individual is the basic unit of measurement. It also assumes that individuals are the best judges of their own welfare, that people will prefer greater welfare to less welfare, and that welfare can be adequately measured either in dollars (or some other unit of currency) or as a relative preference.

Social welfare refers to the overall utilitarian state of society. It is often defined as the sum of the welfare of all the individuals in the society. Welfare can be measured either cardinally in terms of dollars or "utils," or measured ordinally in terms of relative utility. The cardinal method is seldom used today because of aggregation problems that make the accuracy of the method doubtful.

There are two sides to welfare economics: economic efficiency and income distribution. Economic efficiency is largely positive and deals with the "size of the pie." Income distribution is much more normative and deals with "dividing up the pie."

Public Choice Theory

Public choice theory is a branch of economics that studies the decision-making behavior of voters, politicians and government officials from the perspective of economic theory. It can be considered as a bridge between economics and political science. Prior to the emergence of the public choice theory, economists tended to ascribe to the government the role of an infallible controller with perfect information and unlimited power -- an entity, which the economist David Friedman called a "bureaucrat god." However, in practice, bureaucrats and politicians are only humans, and they often face incentives that draw them to decisions that produce inefficient outcomes. Since the basic assumption of the economic theory is that humans are rational beings that act in a self-interested way, it follows that the economic analysis of the political decision-making process might indeed reveal certain systematic trends towards inefficient government policies.

Public choice theorists focus on the question of what government policies are likely to be implemented in a given political setting, rather than what policies would produce a desirable outcome if they were implemented. The conclusions of the public choice theory tend to increase skepticism towards the prospect that giving government power over various areas of human affairs will actually have beneficial results, regardless of the democratic control exercised by the citizens.

One of the basic insights that underlie the public choice theory is that good government policies in a democracy are an underprovided public good, because of the rational ignorance of the voters. Each voter is faced with an infinitesimally small probability that his vote will change the result of the elections, while gathering the relevant information necessary for a well-informed voting decision requires substantial time and effort. Therefore, the rational decision for each voter is to be generally ignorant of politics and perhaps even abstain from voting. The fact that most citizens in modern democracies display gross ignorance of politics is well attested by research, while the elections in modern democracies are usually marked by a low voter turnout.

Taxation Policy

While its main intent is to provide revenue for the federal government, the tax code is frequently used to direct the behavior of businesses and individuals in an attempt to achieve social, economic, and political goals

For example, the tax law provides a deduction for mortgage interest in order to encourage home ownership. A theoretically pure income tax would not allow this deduction, which is not an expense incurred for the production of income. The allowance of the mortgage interest deduction is seen by some as discrimination against taxpayers who rent, rather than own, their home: the payment of rent for one's home is not deductible. Of course in theory, landlords generate tax savings on their mortgage interest payments, and pass these savings on to renters.

Because the government uses the tax code as an instrument of social policy, the code as a whole appears to lack a coherent organizing principle. This lack of a coherent organizing principle has become magnified over time, due to the interplay between successive legislative amendments and regulatory changes to the law and the private sector responses to those amendments and changes. For instance, suppose that Congress enacts a tax credit to encourage a particular type of activity. In response, a group of taxpayers who are not the intended beneficiaries of the credit re-order their affairs, or the superficial aspects of their affairs, to qualify for the credit. Congress responds by amending the code to add restrictions and target the credit more effectively. Certain taxpayers manage to use this change to claim additional benefits, so Congress acts again, and so on. The result is a feedback loop of enactment and response, which, over an extended period of time, produces significant complexity.