Tuesday, 23 October 2012

The taxing problem of tax avoidance #1: the moral question.

It seems that hardly a week goes by these days without the issue of tax avoidance hitting the headlines. First it was companies like GlaxoSmithKline (GSK) that were in the firing line then it was poor old Jimmy Carr.  Now, in recent weeks we have had both the BBC and Starbucks under the spotlight.

Of course central to this debate is the issue of what constitutes a fair tax system. To most that is one where those that have the most pay the most. The reason why tax avoidance is seen to be so invidious by many is that it distorts this principle. A millionaire can end up paying a smaller fraction of his income in tax than his secretary or his cleaner. Indeed in many cases he can end up paying no tax at all. It is not just that he can end up paying less tax that is the problem. It is the fact that he seems to be able to pick and choose which tax he would prefer to pay, and when he would prefer to pay it. In short, it is because there are opportunities open to him that are not open to the general population. Thus the playing field is not flat and it is not fair.

It is probably to be expected that in times of austerity for  many (although not the few) there will be a sense of moral outrage directed at those perceived to be not paying their fair share, but it should be remembered that the political issue of tax avoidance has been with us for many years. It was a particular cause c√©l√®bre in the boom years, and every year the public's expressions of outrage against it appeared to grow louder. So too did the protestations of certain venerable politicians that "Something must be done". Yet nothing ever was done, or so it seemed. Instead what we got were a plethora of appeals to the moral conscience of the perpetrators. Yet what many fail to realize is that morality doesn't come into it, or even worse, that tax avoidance in many cases may actually be the most moral action available.

If you are a tax accountant it is your moral (and legal) duty to do the best by your client. That means finding the lowest tax rate for the client. If you are a company finance director your moral and legal duty is to maximize the return to your shareholders. That inevitably means minimizing the funds paid to everyone else including employees and the taxman. So, when it comes to paying tax, morals are for individuals. When you are handling the tax affairs of others, morality doesn't come into it. It is about applying the letter of the law. So if politicians want to eradicate tax avoidance, then surely the onus is upon them to legislate to that effect? Yet nothing ever seems to change. Now why is that? Is it because it is really so difficult to legislate against tax avoidance? I think not.

You see if you look at all the various schemes on offer for the average man or woman with more disposable income than social conscience, they all boil down to a handful of basic mechanisms. These schemes often involve off-shore companies, but they also tend to exploit the use of loans, rebates, rents, "gifts" or arbitrage to minimize the tax liability of the company or individual. As I will outline in later posts, most of these schemes could be closed down with the right legislation and a modicum of political will.

Thursday, 31 May 2012

The Big Lie #1 - Austerity is needed to appease the bond markets

It is often said that truth is the first casualty of war. It could equally be the first casualty of politics as well. Given the extent to which politicians have appeared to play fast and loose with language and semantics in recent times it is perhaps unsurprising that their collective credibility and reputation, both at home and abroad, appears to be following the same trajectory as that of a test firing of a North Korean rocket. Whether it is politicians being "economical with the actualit√©", or Orwellian doublespeak of the type invoked by David Cameron recently where the term austerity has been magically redefined to mean "efficiency", the first casualty of UK political debate now always seems to be the English language. Of course none of this is accidental. It is all designed to disguise the reality behind a particular policy or action so that the voters are hoodwinked into believing in an illusion. 

One of the biggest fictions we are currently being expected to swallow is the one regarding the necessity of the current coalition government's deficit reduction measures and their apparent success. The argument that has been advanced by those on the Right on an almost daily basis since the last general election in 2010 is that the only way the Government can finance its deficit is if it can establish the confidence of the bond market. And the only way it can do that is if it slashes spending. And the central piece of evidence used to corroborate this claim has been the yields of government bonds or gilts. 

Gilt yields are currently at historic lows despite the Government running up record budget deficits over the last four years. Now we are told that these low yields are a direct result of the confidence that the bond market has in the Government's economic strategy. We are told that the Government cannot, or dare not, borrow any more money to stimulate the economy otherwise gilt yields would rise dramatically. We are told that our economy would then go the same way as that of Italy, or Spain, or worse still Greece! But how much of this is really true? The answer is hardly any of it. The reality is that our gilt yields are low because our borrowing has been almost completely self-financed over the last four years. That self-financing has come in the form of Quantitative Easing (QE). 

Up until April 2002 the last Labour government ran a financial surplus in its accounts. Then over the next six years this turned into a modest deficit of approximately £35bn per annum. While not ideal, these deficits were nevertheless sustainable in the long term as they typically increased the national debt by a smaller proportion than the corresponding annual increase in GDP due to economic growth. As a result the debt-to-GDP ratio was actually declining after 2006 despite the nominal debt level still increasing, and as a result it was actually more serviceable. It is therefore economic fantasy to suggest, as some on the Right have done, that these deficits caused the financial crash. The real cause was the set of economic policies implemented by the Thatcher and Major governments in the 1980s and 1990s, particularly with regards to the liberalization of consumer credit, laissez-faire bank deregulation and a wholly disfunctional housing policy. The result was the worst recession in living memory and a national debt that has increased to £1022bn. Of this total, over £500bn has been added since the start of 2008 - almost half the total. So why have gilt yields remained so low when the supply of gilts from the Government to the bond market has been so huge? The answer is QE. 

Since 2008 the Bank of England (BoE) has "printed" an additional £325bn of new money in the form of Quantitative Easing and used this money to purchase UK gilts. Irrespective of the fact that this was done through the secondary bond market, the net result is that 65% of all the new gilts issued by the Government since 2008 have in effect been acquired by the BoE. That means that only about £180bn have actually been purchased by the private sector, or £45bn per annum. That is only fractionally more than were purchased each year prior to the crash, and this has been going on for nearly four years now. In fact QE has been operating for so long now that the financing of government deficit spending has become semi-detached from the bond market to such an extent that it is almost operating in a parallel economic universe. That is partly why yields are so low and as you can see it has nothing at all to do with the international financial markets supporting the deficit reduction plans of the coalition. 

But that is not the whole story, for one of the additional consequences of the financial crash is that UK banks are now forced to hold more assets to strengthen their balance sheets. As a result UK banks have needed to buy more UK gilts themselves in order to increase their own financial stability. It is therefore highly debateable if there has been any significant increase in the purchase of UK gilts by overseas investors in recent years, yet capital flight from the PIIGS (Portugal, Ireland, Italy, Greece and Spain) has driven up the relative demand for UK gilts.

Only yesterday did we see further worries about the Spanish economy driving yet more capital away from the Eurozone and forcing it to look for safer havens elsewhere. The result was a further drop in UK gilt yields. And all of this is happening at a time when the supply of UK gilts, contrary to popular opinion, has actually been significantly reduced, or has at least been far less than the headline figure of the UK government deficit. So, given these two complementing drivers, it should hardly be any surprise that UK gilt yields are so low, irrespective of the general state of the economy, which in case you had missed it, is lurching from one recession to another. That is hardly the sort of performance that is usually associated with inspiring the confidence of international investors. 

You can of course look at all this from another perspective: that of the balance between supply and demand and its effect on market prices. Low gilt yields are an indication of excess demand and insufficient supply. Consequently they represent a market price signal that says: "The market wants more!" In which case why should we not supply more gilts to the market, particularly when we can put those gilts to good use? Those who believe in the power of markets, and the price signals that they send, cannot have it both ways. If high yields are a sign that government borrowing is too high, then low yields can be a sign that it is too low. And as I pointed out previously, when it comes to low interest rates you can have too much of a good thing. Ultimately banks, including central banks, cannot push money out into the economy when there is no demand, or no cost to holding it. In such circumstances monetary policy is like pushing against of piece of string and a coordinated and complementary fiscal policy is then also needed. 

Of course the real tragedy is that despite having access to what has effectively been free money for four years, both the last Labour government and the current coalition have failed to do anything effective or imaginative with it. Rather than using it to stimulate a programme of infrastructure investment, it has instead been used to refinance the banks, and indirectly to prop up house prices. Once again successive governments and the Bank of England have shown that they are more worried about negative equity than they are about unemployment; that they prize inflated asset values over real economic growth. As a result, all this free money has in effect been used to insulate the rich from the consequences of their own mal-investment rather than improving and protecting the lives of the poor. 

The choice of austerity is therefore a political choice not an economic one. Just because there is a lot of debt in the economy does not mean that there is no money at all. It just means that all the money is in the pockets of the wrong people. The current government with its tax cuts for the rich and its attacks on the incomes of the poor clearly wishes to keep it there.

Monday, 19 March 2012

The Budget 2012: Should George Osborne learn from Barack Obama?

This was the question that Larry Elliott asked on The Guardian's Economics Blog yesterday. He was of course referring to fact that the USA has implemented a major economic stimulus package whereas the coalition government here has instead (with the tacit encouragement of the Treasury) been implementing a policy of cuts and austerity. As a result the USA has had falling unemployment for most of the last year whereas in the UK unemployment is still rising. In the USA economic growth is well over 1% and approaching 2%. In the UK it is barely above zero. So has Obama got it right and Osborne got it wrong?

To answer this we must first take stock of what it is exactly that the US government has done. Its stimulus package has in fact been in three parts. First it reduced its short-term policy rate (just as the Bank of England did). Then it introduced Quantitative Easing (QE), just as the Bank of England did. Then last autumn it launched Operation Twist. This involved buying long-dated bonds to bring down long-term interest rates and replacing them with short-dated bonds, but as Operation Twist is such a new initiative can it really be held responsible for a US recovery which has been underway for over a year now? Probably not, and as Larry Elliott suggested in his column, it is difficult to see how Operation Twist could really effect aggregate demand. So is the real explanation for the difference in recovery rates between the US and the UK just down to the size and length of the stimulus. Perhaps not.

Perhaps the real reason that the US economy is growing faster is not just down to the federal stimulus. A point that is too often overlooked has been the scale and the effect of the housing crash in the US over the last four years. Unlike in the UK where house prices fell by only about 20% from their 2007 peak and are still at historically high levels, in many parts of the US the fall has been much more dramatic. Could this be part of the reason that the US economy has seen a better speed of recovery?

In case you had forgotten, it was the boom in the housing market in both the USA and Britain (and Ireland and Spain for that matter) that led to the financial crash in 2007, rather than just a failure of bank regulation. In all of those countries mentioned the housing bubble was the result of either rising inequality or increasing economic imbalances and, in the case of the US and UK, stagnant growth in real wages for the less well off as well. As a result an excess of investment funds got misdirected into creating bubbles in asset prices (i.e. property) instead of being use to create new means of production.

What is different about the US response to the crisis, compared to the UK one, is that the US allowed their housing bubble to implode. We did not. In fact government policy in the UK is still more concerned about supporting house prices than it is about keeping people in work. That is the big mistake. Negative equity is only an economic problem if people start losing their jobs.

In the USA by contrast, by allowing the housing market to crash the policy makers have forced the debt holders to take a "debt haircut" and thus allowed the economy to partially reset itself. Thus the USA has benefited from a combination of a debt haircut and a stimulus. In the UK we have had a weak stimulus primarily for the banks but no haircut. In the Eurozone (e.g. Spain and Ireland) they might get a small debt haircut but no stimulus. Thus it is the combination of stimulus and debt write-off that is the necessary remedy. Those countries that only take half the medicine either take much longer to recover, or don't recover at all.

However it is not just about the size of the stimulus either. It is also about the shape of it. The correct economic response to the current crisis is not just to provide a stimulus, but to direct that stimulus towards correcting the original cause of the problem, namely the housing market. By building more social housing the government would not only have created jobs, it would also have reduced house prices and private sector rents and thereby increased disposable incomes for the majority of families. That would have magnified the effect of the stimulus and helped to eradicate the core problem. Instead we are having to endure an economic policy that protects the haves at the expense of the have-nots. That is just a repeat of the very economic policies that caused the whole sorry problem in the first place.

Tuesday, 21 February 2012

Why a zero interest rate equals zero lending

Adam Posen is an American economist who currently sits on the Bank of England’s (BoE) Monetary Policy Committee (MPC). This is the committee that sets the UK’s interest rates in order to control CPI inflation, or at least that was the original idea behind the formation of the MPC in 1997 when Gordon Brown was Chancellor of the Exchequer. I mention this because a couple of weeks ago Mr. Posen was quoted in an article by Philip Aldrick in The Daily Telegraph as described British banks as “reluctant, risk-averse jerks”. He may be right, but is that such a bad thing, particularly given the reckless lending that preceded 2007? I thought we all wanted banks and bankers to be boring again. Obviously not!

It occurs to me, however, that one of the issues that both the Daily Telegraph article and Adam Posen’s recent comments apparently fail to highlight is the possible causal effect that low interest rates can have in reducing bank lending. The point that virtually no-one in economics and the political media has so far cottoned onto is this: when base rates are high banks are forced to lend virtually all the deposits they receive in order to pay the interest that they owe to their savers, but when base rates are low there is no such necessity. To understand why, consider this simple example.

In normal economic times bank base rates may be about 5%. So, suppose a bank receives deposits of £1m for which it must pay interest at a savings rate of 4.5%. If the bank is required to maintain a capital adequacy ratio of let's say 10%, it will only be able to lend out 90% of its deposits. But it must also lend sufficient money at a sufficiently high rate of interest so that it can bring in enough revenue through loan interest repayments in order cover the interest it owes to its depositors. At the very least that means it must lend all of the available deposits (£900,000.00) at a rate of 5% just to break even. It could of course lend out less (say £750,000.00) but then it would need charge a higher loan rate in order to make a profit (in this case over 6%).

When you add in the effects of competition between banks, that competition will have two effects. Firstly, it will force down loan rates (or force up saver rates); and secondly, that will then force banks to lend more and more of their available deposits in order to cover costs and maximise profit. This inevitably means that banks will be unable to sit on deposits. Instead they will be incentivised to make those deposits work as hard as possible, possibly to the extent where some banks try to circumvent the rules on capital adequacy. That of course was what happened during the credit boom with disastrous consequences. But that is not what is happening now.

Today base rates are anchored at 0.5% and look like staying there for several more years to come. As a result savers typically receive an interest rate of about 0.2% if they are lucky. Yet most loan rates still exceed 4%, while for credit cards and unsecured loans they are much higher still. Under circumstances such as these banks would only need to loan out about 5% of their total deposits in order to break even. The net result is that they can pick and choose with even greater selectivity than before who they choose to lend to, and how much they choose to lend. The credit market therefore becomes highly skewed in favour of the lender. So that would appear to explain, at least partially, why current levels of bank lending are apparently so weak. In which case is Adam Posen right to criticise the banks in this way? Or should some of the responsibility for this lack of lending also lie with Adam Posen and his colleagues on the MPC? After all, it is they who set the BoE's base rates and, as I have shown, it is those base rates that help to drive bank lending.

With UK interest rate policy set as it currently is, what has in effect happened is that lending rates have become decoupled from savings rates. Once you realize that then it becomes apparent that having base rates at 0.5% serves very little purpose as far as the wider economy is concerned. It certainly has no effect in stimulating increased loans to small businesses, and while that may not be the only reason for the poor lending record of banks, it is probably a contributory factor. The result is a credit crunch or liquidity trap where those with spare cash refuse to either lend it or spend it. The critical issue here is the same one you get in price deflation in a depression. Both are caused by the tendency of the rich to hoard cash when there is no financial penalty for doing so.

Normally, hoarded cash loses it value through inflation. That is why a small amount of inflation actually benefits the economy as it helps to drive the circulation of money through spending, investment and consumption. Similarly, un-loaned bank deposits normally lose value for the banks due to the costs of interest they incur that must be paid by the banks to their depositor customers. When inflation and interest rates are negative, however, these conditions no longer apply, and the cash or credit stops flowing. In short, when savings rates are close to zero the banks effectively have access to free money.

Of course there are other reasons for the general lack of lending to small businesses. One of the main ones is the competition for funds from house-buyers via the mortgage market. In the period immediately prior to 2007 over 75% of bank lending was on mortgages, with only about 6% being made available to small businesses. This represents a classic case of "crowding out". That is why part of the long-term solution has to be the establishment of a network of locally based investment banks in the UK based on the German model of financial support to its Mittelstand. What is clear is that the more choice banks have over where they lend their money, the less likely they are to lend it in support of the real economy. It is simply a question of reducing the number of options or degrees of freedom banks have. As Adam Posen is also quoted as saying: "We've got to change the competitive pressures on them, change the rules on them so they're forced to do the job right."

What the above statistics also show, though, is that like most of the UK's economic problems, the ongoing problem of underinvestment by UK retail banks in the rest of UK business is intrinsically linked to the perennial UK problem of property speculation and house price inflation. So you will never solve the investment problem unless you also solve the housing problem.