Sunday, 18 August 2013

Football economics part 1: transfer fees

This weekend is the start of the Premier League football season. Hooray! Or maybe not? As a football fan even I am becoming disenchanted by the role money plays in the game today, the effect it has on motivating or de-motivating players, and the contribution it makes to the financial instability of clubs of all sizes. So perhaps it is time we started asking if the economics of football can be redesigned, and we could start with that most topical of issues: transfer fees. 

The last few weeks have seen the sports pages of our national newspapers monopolized by speculation over the future of players like Luis Suarez, Cesc Fabregas, Gareth Bale and Wayne Rooney. Of particular interest has been the £40m clause in the contract of Luis Suarez which bares a certain similarity to the buy-out clauses that often feature in the contracts of players at European clubs. These clauses are supposed to represent the amount any other club would need to pay to acquire that player, except that the buy-out clause is hardly ever enforced, and when the player does move clubs it is usually for a much smaller fee. 

Of course the Suarez clause isn't technically a buyout clause, so at the time of writing Suarez is still a Liverpool player, and in theory there is nothing that any bidding club or Luis Suarez can do to change that situation. But as we have seen in the past, if the bid is large enough then the club will sell irrespective of the wishes of the player, and if the player demands a move strongly enough then he usually gets his wish irrespective of the wishes of his current club. The result is a system that suits no-one, that is opaque and arbitrary, and which appears vulnerable to external manipulation and corporate bullying. 

The current system is therefore clearly dis-functional. The contracts often appear to be meaningless, particularly to supporters who expect total loyalty of the player to the club and the contract. However those same supporters are less exercised when it comes to selling players that the club no longer wants. And when it comes to the players themselves there is an equal degree of hypocrisy. Players have temporary fixed-term employment contracts that they expect to be honoured in full if they suffer an injury, but which many try to break if they see a better opportunity elsewhere. 

So is there a better way for players to be exchanged between clubs? I think there is. As money is the facilitator of such actions then the answer must lie in the economics of the transfer process. At the centre of any transfer policy must be the market value of the player, or his marginal utility. It is fairly easy to calculate what this should be. It will be determined by the player's salary and his length of contract. At any given time an employee's wage is supposedly (in neoclassical theory) determined by the company's gain in net revenue that results from his employment. Therefore his annual value to the company is determined by his salary. His total value over time will be set by the expected duration of his working life at that club and his average annual salary over that time period. For a footballer his expected working life at his current salary is set by the length of his contract. Risk of injury, age and loss of form are all factored into the contract length. Therefore the total marginal utility of the player is set by his current salary multiplied by the time left on his contract. 

The advantage of this formula is that everyone would know where they stand. The player and his current club would know that if a rival club were to bid more than the product of the player's current salary and the remainder of his contract then the player can move. His current club would know that if they wish to ward off such rival bids then they must offer the player either a longer contract, or a higher salary. And everyone would know that the closer that a player gets to the end of his contract the less his transfer fee will be. In that sense this idea merely formalizes the situation that already operates in practice where players with only one or two years left on their contract start to see their transfer value decline. 

The net result of such a change would be that transfer fees would probably fall and players' wages probably rise, with the wages of the very top players being most affected. Whether that is good or bad depends on your perspective (I will deal with the question of clubs' income and player salaries in another post), but it would mean that transfers of players would be smoother with the player's current club being unable to block such moves with outrageous demands over transfer fees. (Is Gareth Bale really worth £100m, or Suarez worth more than £40m?) In return though, the selling club would be guaranteed a fair fee. It would also mean that the most valuable players would move to the teams where they would have the greatest marginal utility. But more importantly it would rid football of the current tug-of-love fiascos that are played out in the media between players and competing clubs, as well as the tapping up of players, and all the other mechanisms by which clubs, journalists and agents seek to unsettle players in order to force a move, often at below the market rate.

Friday, 5 July 2013

Loony policy proposal No. 1 - 200 GBP visas to deter use of NHS

Have we reached the silly season already? It seems like it with this proposal. 

Political parties are rarely any good at coming up with workable policies when they are in office, but then again they don't seem to be much better at it when they are out of office either. And when it comes to the design of inept policies they don't get much wackier than this one. It therefore seems entirely apposite to start a new series of articles highlighting such political ineptitude and fuzzy logic with this real corker of an idea. 

The ConDem coalition's latest big idea is to charge all overseas non-EU visitors an extra £200 for their visas in exchange for the right to use the NHS when they are here in the UK. The alleged reason for this policy is to counter so-called health tourism where overseas migrants come to the UK to use our NHS but then avoid paying for the treatment they get. The first question, therefore, is will this policy work? Will it deter people from coming to the UK just to use our health service for free? 

The answer to this is clearly no. Charging foreigners £200 pounds is going to be no deterrent when the potential benefits are health costs that could be a hundred or a thousand times greater. In fact £200 is even barely significant when compared to many international air fares. So where is the actual deterrent? In fact you could argue (and Richard Murphy does) that the new policy could actually increase the scale of the problem by legitimizing it. That, however, is not the only massive flaw in this policy. 

The second question is does it result in any adverse or negative consequences? The answer here is clearly yes. In effect the proposal is to levy a tariff on all foreign visitors in order to pay for a minority that might abuse the NHS system. But that means that the majority will be punished for the actions of a minority, and as the majority are free to avoid the tariff by simply travelling to another country, the result is likely to be a substantial fall in students and tourist numbers entering or visiting the UK. So not only does the policy not deter the people it is supposed to, it instead actively deters the people we want and need to come here to boost our economy. 

The third test of any policy should be, do the benefits outweigh the costs? The answer here is also clearly negative, as the results of the first two tests do not even begin to compensate for each other. They are clearly both additive and negative. So the sum of the two effects in massively negative. 

The fourth question any new policy needs to address is, do we need it? Well in the case of health tourism no-one really knows how big this problem is. It may cost the country £12m a year or it may be £200m, but either way it is still insignificant in comparison to the size of an NHS budget of £109bn. So this policy clearly fails the fourth test of any workable policy - necessity. 

So what we have is a policy that we don't need (yet), that will fail to deter the people it is designed to deter, that will instead deter the overseas visitors we want and need, and may in fact even encourage the problem of health tourism to grow further by legitimizing it. It really does take a phenomenal degree of incompetence to invent a policy that is quite that useless and counterproductive. 

Sunday, 2 June 2013

Tax avoidance #3: transfer pricing

When will they ever learn? Just when it looked like a politician had finally begun to get real over tax avoidance Ed Miliband goes and shoots himself in the foot again.

First he pledges that if elected PM he will tackle corporate tax avoidance without international agreement if necessary. So far, so good. But then he falls for the same misguided arguments as the rest of the political class by seeking to blame the existence of avoidance techniques on the companies that use them. Principal amongst these is the technique known as transfer pricing.

This is a technique used by multinationals where the prices for goods or services traded internally within the company but across international frontiers are set either artificially high or artificially low in order to move profits from one (high tax) country to another (low tax) country. As a problem it is not new. Economics texts have been highlighting the issue for over forty years (for proof see Chapter 19 of Economics of the Real World, by Peter Donaldson, published in 1973). The received wisdom is that all that is needed in order to counter this activity is some form of international agreement, greater corporate transparency, more resources for HMRC staff and a modicum of moral pressure. Robert Philpot of Progress tried to make some of these arguments again last week on the Huffington Post. Yet none of this is true.

As I have pointed out before, under capitalism companies are driven by the imperative to maximize profit, not some moral obligation to maximize government tax revenues. The moral choice is to do what is best for the shareholders, not what is best for the wider community. And anyway, why should Google or any other company be obliged to pay more than it needs to in tax when to do so could put it at a competitive disadvantage with respect to its rivals?

The arguments in favour of international agreements are equally flawed. Such agreements would require all countries to sign up to the same set of rules as those that didn't would gain a competitive advantage over those that did. Yet as long as countries compete against each other to attract multinational corporations to their territories, either in order to generate greater tax revenues at the expense of other nations, or to attract inward investment at the expense of other nations, then there will never be any hope of a binding international agreement. There will always be one country that refuses to be bound by the wishes of the majority in order to gain advantage. And given the size of multinational profits in comparison to national incomes, the power to undercut on tax will always favour the small nation (e.g. Luxembourg, Switzerland, Austria, Ireland) over the large nation. Countries like the USA and UK can therefore never hope to compete with these smaller countries by lowering their corporate tax rates. They need to look for a different approach. That means implementing tax laws that are not reliant on the actions or agreement of governments in competitor countries, but are instead based on objective measures of business activity within each country's own borders. One possible solution is the Common Consolidated Corporate Tax Base (CCCTB) proposed by the EU.

At the heart of the transfer pricing problem is the thorny issue of corporate profits and how they are calculated. Even at the best of times the quantification of a company's true annual profit is something of a black art, one that is complicated by one-off asset write-downs, debt interest, rolled over losses from previous financial years, and the deferral or front-loading of capital investment. Yet over time most of these factors cancel themselves out. However, on top of all that there is the problem of how those profits are spread across the different divisions of the company. Again, if all the divisions of the company are located within the same country it matters not a jot. The total profit of the company in that tax jurisdiction is the same however it is divided between subsidiaries, and so the tax paid is the same. Yet, as soon as the profit is spread across subsidiaries in different countries with different tax rates, problems abound.

This is where transfer pricing comes into its own. There are a number of variants of this type of scheme that essentially only differ in the form of the goods used as the vehicle for the price transfer mechanism. In its most classical manifestation the goods are typically manufactured components of a larger or more complex final product. However, increasingly transfer pricing schemes have begun using brand licences or other intellectual property as the good that is traded internally within the company (as used for example by Starbucks). As an illustration of how transfer pricing works it may help to consider the following hypothetical example.

Suppose a car maker has two production facilities. The main assembly plant is in the UK and is owned and run by subsidiary A. However, the engines are manufactured in country Z by the company's subsidiary B. Now suppose it costs £4000 to build the engine and another £4000 to construct the rest of the car, but the car sells for £10,000. The profit is therefore £2000 per car. If the car company builds 1,000,000 cars each year then its annual profit will be £2bn, but which in country should this profit be declared and taxed; the UK or country Z?

The answer is that it depends on the price that subsidiary B charges subsidiary A for its engines. For most goods bought by ordinary consumers or firms the price is set by the market and it is therefore beyond the capabilities of any single agent to dictate this price unilaterally. In transfer pricing schemes, however, the commodity or good at the centre of the scheme is only ever traded within the multinational company. There are no external customers and so there is no objective market price for the good. Whatever the multinational charges for the good it ends up paying to itself, so it can set its own price for its own reasons. That reason is usually tax.

In the above example the cost of producing the engine and the car body is the same (£4000 each), so one might naturally assume that the fair way for the profits to be divided between the two subsidiaries would be in the same 50:50 split. In which case subsidiary B would charge £5000 for each engine, thus allowing it to make a profit of £1000 per engine. Subsidiary A in the UK would then buy the engines for £5000 each, build the rest of the car at an additional cost of £4000, and then sell the cars to the public for £10,000 each. Thus the cost of manufacture for subsidiary A is £9000 per car and its profit is £1000 per car, the same as for subsidiary B. If the tax rates in the UK and country Z are the same, let's say 30%, then the multinational will pay £300m of tax in each country, or £600m in total.

But if the tax rate in country Z is lower than in the UK (say 25% instead of 30%), then the car maker will pay less tax in country Z (£250m) than the £300m it continues to pay in the UK. Its total tax bill at £550m is now less than the £600m it was originally. But it can reduce its tax bill even further by raising the price of its engines.

If subsidiary B charges £6000 for each engine, then subsidiary B will make £2000 profit per car. Yet the cost of production for subsidiary A then rises to £10,000 per car, £6000 for the engine and £4000 for the body, and so it makes zero profit. Now all the profits are taxed in country Z at 25%, and so the total tax bill falls to £500m.

Similarly, if the UK were to retaliate by lowering its tax rate to 20% (as advocated by Osborne and Cameron) then the car company would respond by changing the cost of its engines once more. Now subsidiary B might charge £4000 for each engine so that it makes no profit while subsidiary A earns £10000 for each car sold but now spends only £8000 on their manufacture (£4000 on assembly costs and another £4000 buying the engine from subsidiary B). As all the profits are now located in the UK they will be taxed at the UK rate and the total tax bill for the company is now £400m.

Thus by raising or lowering the cost of its engines (or any other internally manufactured component) the car maker can in effect choose which country it wishes to be taxed in. And in so doing it can also force countries to compete against each other by competitively reducing their tax rates in a self-defeating race to the bottom where the only winner is the multinational.

One reason why the scheme is so difficult for governments to challenge is that there is usually no other external customer for the good or service used in the transfer pricing, so the price is difficult for the tax authorities to challenge. In addition, multinationals can always find one country to base their headquarters in that will offer a lower tax rate than any other. Worse still, with complex lines of procurement it is doubtful whether even the company itself can accurately determine the true cost of many of its internally sourced components. Nevertheless, despite these difficulties it is clear that many multinationals actively operate aggressive policies of tax avoidance based on transfer pricing that are designed to minimize their corporate income tax bill. It is therefore time governments adopted an alternative approach to tackling the problem.

The Solution:
There is only one realistic solution to the problem of transfer pricing, and that is to tax companies on the basis of data that they cannot challenge or manipulate. As already noted, profits can have a distinctly ethereal quality at times, particularly when looked at on a country-by-country basis. However, a company's global profit (P) is much more tightly defined. So too for that matter are other global aggregate measures of a company's performance such as its global sales (S), its global wage bill (W), and the total value of its global capital assets (K).

It is also true that, while a multinational operating in the UK can disguise its UK profit via transfer pricing, it cannot disguise the level of its UK sales, wage bill or capital investment. Its UK sales are already recorded for VAT purposes, and its wage bill for calculating its national insurance liability. As for its UK capital, that is mainly in the form of property, which is also rather difficult to conceal.

It therefore follows that governments should take the initiative when it comes to determining the profit levels of subsidiaries operating in their territories. As neither the government nor the multinational really knows the true profit level of these subsidiaries, the government should in effect use the objective data outlined above to tell the multinational what its UK profits are, rather than relying on the multinational to tell the government what it thinks it is. And it turns out that a formula for just such a calculation already exists.

In an attempt to tackle the issue of transfer pricing the European Commission has proposed the Common Consolidated Corporate Tax Base (CCCTB). This utilizes data for the company's global sales (S), wages (W), capital (K) and profits (P), together with the equivalent terms Si, Wi and Ki pertaining to any individual country i only. This allows the company's profits in country i to be estimated by taking a weighted average of the fraction of its global capital, sales and wages that are deployed in that country, and using that average to set an estimate for its profits in country i. In the absence of any more authoritative data, this estimate will de facto be assumed to be the true profit level Pi for the subsidiary operating in that country.

The coefficients are defined to be the same for all companies operating in country i, and are then set such that each is less than unity, and their sum is always equal to unity as follows.

In practice these coefficients are all likely to be set to be equal to each other as there is unlikely to be much overall variation in the proportion of wages, sales and investment capital for all multinationals within a given country i. In which case the profit in country i becomes

We have then a profit calculating mechanism that is impervious to transfer pricing. Companies cannot manipulate their profit in country i because they cannot manipulate the quantities used in Eq. (3) to calculate that profit. It is this type of approach that politicians and government tax advisers should be adopting, not the empty rhetoric of cynical political posturing.

Monday, 27 May 2013

The right way to regulate and rescue banks

When it comes to the question of how (or even if) we should rescue failing and insolvent banks, so far the choice on offer has been between two equally unpalatable brands of medicine. Either the State should do nothing (as the neo-liberal Right are forever demanding) and risk contagion spreading within the financial system as the collapse of one bank leads to the decreasing creditworthiness of others, or the State should act as ultimate guarantor for all deposits and thereby institutionalize moral hazard, effectively legitimizing every bad investment every bank or investor has ever made. As I pointed out in my last post, the central problem is a triangular paradox at the heart of the current bailout provisions. For an orderly restructuring of a bank to be achieved while protecting the wider banking system, the economy and the taxpayer, three key objectives need to be met.
(i) No taxpayer funds should be used in any bank rescue.
(ii) The bank's customers must still be able to access some deposits.
(iii) There must be no capital flight or run on the bank.

As I also pointed out previously, these three conditions are fundamentally incompatible with each other. Only two of the three can be achieved at any one time. If the bank remains open for business in order to service the day-to-day needs of its customers, and at the same time the taxpayer is to be relieved of any compensation obligation, the depositor will be forced to bear the cost of bank restructuring. The inevitable result will be capital flight as the depositors seek to avoid the impending financial penalties, and so the taxpayer will be forced to step in. If, however, the bank is closed for business to protect against capital flight, then the taxpayer will be protected but the wider economy will suffer as businesses and their customers run out of cash, many firms will be forced to close down, and the economy will start to slump.

There is though a second iniquity with the current system as I again outlined previously. This applies to customers who may have the misfortunate of receiving a once-in-a-lifetime large cash deposit (e.g. from a house sale or lottery win or business deal) that temporarily flows through their bank account at the very instant that the bank enters its state of crisis. So when the bank's restructuring or liquidation is complete these unfortunate souls will lose almost everything. Unlike conventional depositors, these customers have yet to make any investment decisions with regard to their new deposits. They are merely using their bank as a conduit through which to transfer the money to its final destination, a destination that may ultimately involve payment to a third party with no net gain for them (as for example during the process of moving house). So why should they be punished when they have not yet sought any high-risk reward? Clearly they should not. In which case, how can we then ensure that we protect these customers from suffering catastrophic and life-destroying financial penalties?

The answer to both this question and our initial capital flight problem is the same. Our initial paradox rests on the fact that we want bank accounts to operate in two distinctly different ways. On the one hand we want them to be fully accessible while at the same time we wish to prevent excessive withdrawals in a time of crisis. The solution, therefore, is to define two classes of account within each bank with each class having its own distinct rules with regard to its level of accessibility in return for differing levels of insurance protection. As a result one class will be applied to current accounts, with the other being for savings. This leads logically to the following 8-point plan, as this post will explain.

1) Set different compensation and access rules for current accounts and savings accounts. .
2) Current accounts to remain instant access.
3) Current account deposits to be fully insured by the Government.
4) Current accounts to be restricted to low interest rates.
5) The bank's own capital reserves (Tier 1 capital) to be set to cover at least 100% of all current account deposits.
6) Savings deposits to be used to cover bank losses when Tier 2 capital is exhausted.
7) Savings accounts to be time-locked in an emergency to prevent capital flight.
8) Bank restructuring to be by debt-for-equity swaps.

The key to the bank insolvency problem ultimately lies in the accessibility of the bank's different customer accounts. One type of account needs to be "instant access" so that normal banking functions can continue for most customers. But if the deposits in such an account are to be freely accessible, then they must be fully guaranteed by the State in order to guard against capital flight. As the generosity of this protection necessarily brings with it the risk of creating moral hazard, the guarantee must therefore be limited to only the most conservative of all investments. That means those carrying the lowest financial reward or yield. So a state-backed 100% deposit guarantee can only be applied to accounts with the lowest of interest rates, with the additional quid pro quo for the customer being that the guaranteed deposits remain available for instant withdrawal at all times.

However, while the taxpayer may act as guarantor in the above scenario, he must also be protected from having to fund the bailout. He may provide liquidity during the bailout process, but he expects to get all his money back (with interest) when it is complete. This means that the bailout must be self-financing. For this to be the case, the bank's own reserves of capital - its equity - must be greater than the liabilities that these reserves are required to cover, namely the current account deposits. In addition, the reserves it maintains would need to be of the same class as the deposits that they are designed to protect. That means that they would have to be in the form of cash, or government bonds that are highly liquid, easily convertible to cash and of secure value.

The next and complementary step is obviously to equate accounts with higher financial rewards with having a higher level of risk and therefore reduced level of state-backed guarantee. With no 100% guarantee over the security of their deposits these accounts will inevitable experience severe capital flight if they too are granted instant access. Therefore some form of time-lock must be imposed on such accounts such that no money can leave these accounts until the restructuring process is complete.

In the event of a bank suffering such increasing levels of bad debt that it begins to affect the very creditworthiness of the entire institution, then the following event sequence would play out. First the bank would freeze all high interest accounts while restructuring took place. This is a similar move to that imposed on the main Cypriot banks in March with the exception that in the Cypriot case the entire bank was closed for business, not just access to its savings accounts. The funding for any bailout would then come from deposits in these high interest accounts via a haircut. However, unlike the Cypriot case, the haircut would not be in the form of a simple forfeiture or confiscation, but should instead be a debt-for-equity exchange with depositors receiving new shares in the bank with the same market value as the total amount of funds that they stand to lose. The same deal should be granted to bondholders and the holders of any other form of the bank's debt. The only remaining question then concerns how the bank's new shares should be valued. Should it be determined by the price pertaining at the very instant that the bank's share were suspended prior to it ceasing to trade normally, or should it be set by the price pertaining at some earlier point in time when the bank's share price was still stable? Ultimately the answer will depend on a political decision as to which parties should be forced to forfeit the most: shareholders or creditors?

The advantages of this scheme are four-fold. Firstly it extends the haircut to other creditors of the bank like bondholders but on similar terms. Secondly, the large increase in shares results in a diluting of the share capital thereby extending the haircut to shareholders. As the value of deposits in the bank prior to its collapse will massively exceed its market capitalization, these measures will ensure that the shareholders suffer greater percentage losses than depositors as should be the case. The third advantage of this deal is that it ties in the depositors to the bank when the restructuring is complete. If depositors start a run on the bank once it reopens by removing their remaining savings, then they risk collapsing the bank and wiping out the value of the shares they received in lieu of their confiscated deposits. Finally, the new share issue ensures that once the bank reopens after its restructuring, not only will it be financially sound (as its liabilities will be much less than its assets), but it will be able to begin trading as normal immediately, as will trading in its shares.

With these measures in place the State would not in any likelihood actually have to bail out the bank. The State would merely stand as guarantor of last resort perhaps providing bridging loans or liquidity to enable the bank to smoothly implement the above process.

Finally, as the two types of account are clearly distinguished by their relative rewards (i.e. interest rates), with the risk associated with each account being dependent on that reward, it logically follows that the division line between the two account types should itself be set by the level of reward. As that reward is the interest rate in each case, so the division line must be based on an objective standard of this type, in other words a standard market interest rate (e.g. BoE base rate, or LIBOR, or base rate + x, etc.). Given the relative values of the Bank of England (BoE) base rate, current account interest rates and most savings rates at the current time, it is likely that under current market conditions the boundary line between our two classes of bank accounts would be set by the BoE base rate.

The mechanism outlined above therefore requires banks to hold two types or levels of capital. One must be highly liquid and sufficient to cover current account deposits. The second would be used to protect against bad loans. This is similar to the current system as introduced under the 1988 Basel I accords where Tier 2 capital was supposed to be used as a reserve of capital that banks could use to cover the cost of bad debts and defaults by customers, and Tier 1 capital was supposed to provide a capital reserve of last resort that would fund the winding up of any insolvent bank.

As we now know, Basel I rules were insufficient to prevent the collapse of banks and other financial institutions after 2007. The new Basel III rules are designed to strengthen financial regulation by forcing banks to hold more capital. Yet these new rules are fundamentally flawed for two reasons. First, they take no account of asset price inflation and how that undermines the solvency of banks by allowing them to increasingly leverage their balance sheets to an extent that only becomes critical when there is a massive crash in asset values. But secondly, there is nothing in Basel III that provides for safe defaults of banks, or that will protect economies from the moral hazard that comes from cleaning up the mess arising from bad banks that are too big to fail.

The structure outlined here might just help do the latter, although other measures are needed as well. These would include provisions for other bank liabilities such as redundancy payments for staff as the bank downsized and rules for the protection and sustainability of pensions. There would also need to be a new set of rules concerning the level of deposit protection afforded to high-risk savings accounts and the necessary capital reserves needed to fund such protection. Imposing haircuts on small savers will never be politically acceptable, but the level of any deposit guarantee will have to be determined by issues of affordability and risk.

Equally important, though, is the need for better preventative measures. These should include new rules that actively discourage and de-incentivize acquisitions and mergers, as well as limiting the activities of overseas subsidiaries. Too many banking failures in the UK over recent decades have had their origins in policies of aggressive expansion. The remainder are generally due to sudden corrections in overheated markets in speculative assets, mainly in the property sector. In the case of asset price inflation, what is needed, therefore, is a new set of rules governing the risk-weighting of assets in measures of Tier 1 and Tier 2 capital ratios that are self-limiting as house prices or share prices increase more rapidly than the rest of the economy. Only then will our banks begin to exhibit the financial strength and resilience that we desire.

Tuesday, 14 May 2013

Banking lessons from Cyprus

Why is it that six years on from the collapse of Northern Rock there is still no semblance of any workable administration procedure having been put in place to deal with distressed or collapsing banks? With the recent banking crisis in Cyprus still fresh in the memory it is apparently not only me who is asking this question. Yet there is still no political or economic consensus regarding how governments should rescue banks. Perhaps the reason is because most people have failed to appreciate the paradoxes that the current system creates. The solution to this problem is, I believe, to fundamentally change the structure of bank deposits, as well to limit the way banks capital ratios are set and the way banks are allowed to operate over national borders. 

After 2007 the two big issues were contagion and moral hazard. The Brown government acted swiftly to protect all bank deposits in first Northern Rock and then other UK banks and building societies such as HBOS and RBS because they were worried about contagion. They feared that the collapse of one big bank could bring down another, and then another, and ultimately the whole system. 

The Bush administration in the USA on the other hand allowed both Lehman Brothers and AIG to collapse because they were more concerned about moral hazard. They were also politically antipathetic to any form of state subsidy or intervention. 

Now we have the Cypriot banking crisis where depositors are facing a 'haircut' on deposits above the EU depositor protection limit of €100k. The problem that we are now seeing is that all three of these approaches have significant downsides. At the crux of the problem is a triangle of paradox and conflicting aims or interests that renders the conventional approach unworkable. 

Ideally what most economists and policymakers want to see is an orderly restructuring of a bank in crisis. That means that three key objectives must be met. 
(i) The losses of the bank should be met by the customers and owners of the bank, not the taxpayer. This is the necessary condition to eliminate moral hazard. 
(ii) The bank must be able to continue operating normally throughout its restructuring without adversely affecting the wider economy. In other words, businesses that use that bank need to have their normal cash-flow operations protected so that they aren't destabilized. 
(iii) The restructuring must be carried out in such a way that there is no capital flight or run on the bank. Otherwise the restructuring won't work. The money to pay for it will vanish. 

The problem is that these three conditions are mutually incompatible. It is currently possible to satisfy at best only two of these conditions simultaneously, but not all three. 

For example, it is currently the wish of the overwhelming majority of people and also of most politicians for the excessive risk-taking of the bankers to be borne by the bankers themselves and not by the taxpayer. If a bank fails it should be the shareholders and the senior management that should bear the cost. However the RBS and HBOS situations show that this will never be enough to cover the cost of most bank bailouts. Depositors will invariably have to take a haircut on some of their savings above the €100k limit. But the Cyprus situation shows how politically difficult this could be to enforce. 

Suppose though that the €100k deposit limit can be implemented so that the taxpayer is protected from the cost of the bailout. The depositors will then know that they are all expected to forfeit a fraction of their savings over €100k. Now suppose also that the banking authorities attempt to continue normal operations of the bank while it is being restructured. Such action is essential to ensure that the bank's business customers can pay their bills and thereby safeguard the normal operations of their own businesses. Without this provision businesses will fail due to cash-flow problems, and there will be a domino effect of redundancies and business bankruptcies that will ripple outwards from the stricken bank over time. 

The problem is, if the bank is allowed to operate normally while it is being restructured, and the depositors are forewarned of impending deposit forfeitures, then capital flight is inevitable. No rational depositor is going to leave all their savings in a bank in the full knowledge that most could be confiscated. Thus if conditions (i) and (ii) above are implemented successfully, condition (iii) will clearly fail. 

On the other hand, if capital flight is to be avoided so that condition (iii) is achieved, then only one of the other two possible actions can be implemented. Either the bank is closed for business while the restructuring takes place (as happened in Cyprus) and the deposit write-downs are performed, or the bank remains open but deposits and depositors are fully protected. The first of these options means that only conditions (ii) and (iii) are met, while the second means that only (i) and (iii) are, with the State inevitably having to pick up the final bill for the cost of the bailout instead of the depositors. 

Finally there is a fourth problem. In most discussions of depositor haircuts there is an implicit assumption amongst most neoclassical economists that all depositors are fully aware both of the risks inherent in their choice of bank, and of the limitations in extent of the deposit assurance scheme. While the latter is certainly true now, the former is not and will never be. The balance sheets of most banks are impenetrable to even the most expert of financial advisers. You only have to see how the credit crunch developed post-2007 to appreciate how the culture of rumour and counter-rumour within the financial markets highlighted the widespread ignorance that existed over the size and whereabouts of all the toxic debt. If the market players don't know where the problems are, how can the humble customer? 

And then there is the question of fairness. Implicit in the €100k deposit protection limit is an assumption that those who fall foul of it are only those guilty of chasing excessive returns. Yet what about the homeowner who sold his home for more than €100k on the very day his bank collapsed. Or the business that received payment for a major order on that same day. They too will lose almost everything, not because they sought to overplay their hand, but simply because they happened to have accounts with the wrong bank at the wrong time. Such instances may be rare, but such instances of large payments happen every day in every bank. The probability that such misfortune happens to you may be small, but the probability that it happens at all will be close to unity. So you know it will happen to somebody. Should the financial system play Russian roulette with people's lives in this way? Isn't that what the insurance and regulatory systems are supposed to prevent? 

These then are some of the problems, but there are others, not least in the disjointed and often illogical approach that the current system of regulation takes. These regulations are enshrined in the latest Basel accords, denoted as Basel III. As I will argue in later posts, Basel III is unlikely to correct all the major problems within the banking system. It won't tackle the paradox inherent in the three conditions (i)-(iii) above. Nor will it address problems associated with capital adequacy, reserves, or banks being too big to fail. What are needed are new rules that are fit for purpose. These rules need to resolve the triangular paradox I have outlined here so that insolvent banks can restructure in an orderly and fair manner. But we also need rules that reduce the likelihood of bank failure occurring in the first place. That means introducing new rules on capital requirements that will actively compensate for asset price bubbles, thereby removing some of the main sources of risk in the banking system. It also means having reserve requirements that recognize the systemic risk of large banks and which therefore financially penalize excessive size.

Saturday, 4 May 2013

Let's pay the people to vote

Another election; another poor turnout. 

In this week's county council elections the turnout was barely above 30%, not that we should be surprised. Four years earlier when the same seats were contested the turnout was again only 39.2%. In the local elections of 2011 the turnout was 42.6%. In fact the only recent local election with a turnout of over 50% was in 2010 when it coincided with the general election, and yet even for that general election the turnout was a fairly pitiful 65.1%. While this was an improvement on the 59.4% in 2001 and the 61.4% in 2005, it is still a long way short of the 77.7% in 1992. 

These figures should be worrying for Labour because it is the Labour Party that suffers disproportionately from differential turnout. At the last general election the average turnout in consistencies that returned Labour MPs was about 61%. For those electing Tories it was over 68%, and in one Conservative-held seat (Kenilworth and Southam) the turnout was a staggering 81%. Overall this means that approximately 10% more people vote in Tory-held seats than in Labour-held ones. This goes some way to explain why the Tories need a greater number of national votes to gain a parliamentary majority, and why with 24.6% more votes than Labour in 2010 they only won 19% more seats. 

It is partly this issue of differential turnout that allows the Tories to (falsely) portray the electoral system as being biased in favour of Labour, and thus to provide cover for their attempts to gerrymander the electoral system with policies like the recent one to equalize constituency sizes in terms of voter numbers. Of course their approach conveniently overlooks the other issue that damages Labour: the problem of voter non-registration in many urban areas. As a result there could be as many as an extra 10% of potential voters missing from the electoral roll in these predominantly Labour constituencies.

Taken in combination with the differential turnout problem, these figures suggest that the Labour vote may be over 20% below what it should be, which means that even at the 2010 election Labour's total vote should have matched that of the Tories at around 10.5 million votes, ceteris paribus. The question is, how many extra seats would this have yielded for Labour? I suspect not many as most of these missing votes are in safe Labour seats. Of course that suggests that the 19% extra seats that the Tories won in 2010 is entirely down to an electoral system that actually favours them, not one that penalizes them. So the big question is: how can this problem be rectified? 

So far most of the media analysis has concentrated on issues centred around political apathy. There are many causes for this malaise. The electoral system is clearly one. The combination of a first-past-the-post (FPTP) system and a large number of safe seats clearly makes many voters feel that their vote is worthless. 

Another problem is of course the lack of voter/consumer choice. With elections dominated by swing voters in marginal seats there is a tendency for all three parties to converge on the "centre ground" and to steal each other's policies. As a result most of the potential remedies have focused on changes to the electoral system, of which the AV referendum was a prime example. 

Other solutions have focused on improving the ease of voting. Thus strategies for increasing the number of postal votes have been proposed, as well as making polling day a bank holiday or putting it on a weekend. So far, however, no-one really appears to have considered financial incentives, with the possible exception of implementing some form of lottery. Why? 

Perhaps because it seems to resemble a form or bribery reminiscent of the rotten boroughs of the late 18th and early 19th centuries. Yet politicians bribing the electorate is nothing new, old, or unusually. The tax cuts, privatizations and council house sell-offs under Thatcher in the 1980s were little more than bribes to a certain section of the electorate. In that sense they were truly insidious because they were selective and divisive rather than universal. They only benefited those with large incomes, spare cash or current tenure of council properties. Those who fell outside these groups were left out of the feeding frenzy. Doubtless some would argue that such a measure would run counter to the provisions of the Ballot Act of 1872, but if the "bribe" is merely conditional on voting and not on voting for a particular candidate or party, would that still be so? 

Of course the principal reason why paying people to vote has probably not been considered is the cost. To make it attractive enough to the potential voter each would need to be offered over £100. Yet with around 45 million potential voters the total cost could then be over £4.5bn. If this was only applied to general elections, though, it would still only equate to £900m per annum. That is peanuts for the UK government. Yet there is another solution that would cost nothing in nominal term. Use the shares the government already owns in the privatized banks. The total government stake in RBS and Lloyds TSB is currently valued (according to their FTSE-listed share price) at over £30bn. That is enough to fund a voter giveaway at the next six general elections. 

Earlier this year Lloyds TSB claimed it was close to being ready for privatization. Now RBS is saying the same. However it is highly likely that any share sale would need to be staggered over a number of years in order to get the best price. 

Nor is the idea of giving these shares away a new idea. This is an idea that was originally proposed by some LibDems a couple of years ago. Then in February there were reports that George Osborne may consider giving bank shares away to all taxpayers (does that include poor pensioners and the unemployed?) It is therefore only an additional small step to suggest that such a gift should be conditional in some way. So why not make it conditional on a citizen exercising their democratic right, nay duty, at the ballot box? Let us call it the citizen's dividend. 

It should be clear that while all may benefit from this idea, the Labour Party and Labour voters will benefit the most. A typical Labour voter is more likely to be incentivized to register on the electoral roll and to subsequently vote by a cash windfall of £100-£200 than is a merchant banker living in Surrey. And when they vote they are more likely to vote Labour in order to ensure that the policy would not be discontinued. If the Tories and LibDems copied Labour's policy then they would still lose out because of the greater benefit to Labour in terms of differential turnout. If they fail to support the idea then they risk the loss of even more votes to Labour. And then there are the economic benefits. Most of the shares will be sold on receipt, and the proceeds spend. The result will be an urgently needed fiscal stimulus for the economy, while the universality of the share allocation will help reduce inequality. So where is the political downside?

Wednesday, 1 May 2013

Tax avoidance #2: The GSK loan trick

In an earlier post I argued that tax avoidance is not as immoral as many politicians insist on claiming, but instead reflects the failure of those same politicians to enact laws that are designed to be consistent and foolproof. I also argued that, contrary to conventional wisdom, tax avoidance cannot and should not be tackled through the use of international treaties or agreements, but should instead be countered through the use of unilateral action. The growing use of "baseball arbitration" by the USA and other countries is a salutary warning in this respect for it could in particular enable multinationals to reduce their tax bills by playing countries off against each other in an increasingly damaging game of winner-takes-all. 

The solution therefore must be for countries to be self-reliant, rather than being reliant on others. To demonstrate the point I will outline some of the most common tax avoidance schemes currently in use by multinational companies and then demonstrate how I believe such schemes could be countered through simple changes to UK tax law. The first such example I have chosen centres on one of Britain's biggest companies. 

GlaxoSmithKline (GSK) is a world-renowned pharmaceutical company. However in recent years it has also found itself in the media headlines regarding its tax avoidance strategies in various countries around the world. 

In 2006 it settled a long-running transfer pricing case in the USA, while more recently it won another transfer pricing case against the Canadian government. However, last year a Panorama programme for the BBC highlighted a different type of avoidance scheme employed by GSK that specifically affects its UK operations. The scheme itself used intra-company loans to reduce GSK's corporate tax bill, but as the Panorama programme also highlighted, GSK is not the only company that has apparently used this type of scheme. The programme also alleged that Northern & Shell, the company run by Richard Desmond that owns Express Newspapers and Channel 5 has also operated a similar scheme. But the implications for this type of tax avoidance stretch much wider than the practices of these two companies as this type of avoidance is also closely related to other schemes used by companies such as Wales and West Utilities and the holding companies of certain well-known football clubs that have been subject to corporate takeovers. These so-called leveraged buy-outs (LBOs) also rely on debt to reduce future corporation tax liabilities, and it doesn't stop there. Much of the housing buy-to-let market also exploits similar tax loopholes. The big question then, is how should the tax rules be changed so that such schemes can be permanently outlawed? 

In the Panorama programme it was claimed that the GSK tax avoidance scheme worked as follows. The parent company in the UK sets up a subsidiary in an overseas tax haven (e.g. Luxembourg). The overseas subsidiary then loans the UK parent company a large sum (say £6.34bn) and the UK parent then pays interest (totalling maybe £124m) back to the offshore subsidiary. This interest is then deducted from the UK company's gross profits before it has to pay its corporation tax (at 28%). The scheme thus saves the parent company £34.72m in UK corporation tax. 

Of course the money paid in interest to the offshore subsidiary will be taxed instead by the overseas tax authority (in this case Luxembourg ), but as the tax haven is chosen so that this tax rate is generally much lower than the normal rate of UK tax the net saving can be considerable. In this particular case the money GSK allegedly paid to its subsidiary in Luxembourg was apparently only taxed in Luxembourg at 0.5%, thereby representing a considerable saving. 

Richard Brooks of Private Eye summarized such schemes as follows: "The company puts its money into Luxembourg and borrows it back. It just sends money round in a circle and picks up a tax break on the way." 

As a result, even to the most casual of outside observers, these schemes appear to be performing an "artificial" function. This "artificialness" arises from four distinct properties of the schemes that differentiate them from "normal" business loans. 
(i) The lender and the borrower are essentially the same person, group of people, or organization. 
(ii) The loan is issued by a company that is not necessarily a registered financial services company. 
(iii) The interest rate of the loan is not market tested. In other words, the same loan from the same source and under the same conditions is not freely available to other borrowers or lenders. 
(iv) The borrower is generally seeking to maximize the interest paid, not to minimize it. As a result the interest rate can in effect be set unilaterally by the borrower rather than through competitive negotiation with the lender. 

Properties (iii) and (iv) are clearly evident in the loan arrangements of Wales and West Utilities. The company was created as a result of National Grid's decision to sell part of its gas distribution network in 2005. Since that sale National Grid has paid over £1bn in corporation tax, yet Wales and West Utilities has paid nothing on its similar activities over the same period. 

The reason for this is that the holding company of Wales and West Utilities charges Wales and West Utilities an interest rate of 21% on the loan used to purchase the company. This interest rate is more than three times the standard market loan rate and coincidentally is just sufficient to wipe out the operating profit of Wales and West Utilities. Therefore it pays no tax. 

The Solution: 
This form of tax avoidance could be tackled quite simply by outlawing tax deductions for any loans that exhibit any of the features labeled (i)-(iv) above. Instead the following restrictions should be applied to the eligibility of all loan interest for tax relief in order to eradicate the problem once and for all. 

(i) The company loaning the money and the company borrowing the money must have no significant commonality of ownership. They must have different directors and different shareholders, and one company cannot be owned in any significant part by the other, or be part of the same corporate group, even if one company is operating in a different tax jurisdiction. 

(ii) The company providing the loan must be a financial institution regulated in the UK by the FSA or FCA. Loans from institutions outside the UK would then not be tax deductable. While some will argue that this might put up finance costs for legitimate loans, the counter argument is that using such overseas lenders increases the UK balance of payments deficit which is also undesirable. This condition is however essential if large multinationals are not to exploit their dominant position within the shadow banking system to further inflate their own already considerable stockpiles of cash at the expense of ever lower national tax revenues and greater wealth inequality. 

(iii) The company receiving the loan must also be able to show that the interest rate is market tested. In practice this will mean that the company receiving the loan must be able to demonstrate that it is not the only customer of the company providing the loan but that there are many other customers of the same financial provider. 

(iv) The company receiving the loan must be able to show that the interest rate has been set in line with the market rate and has not been inflated for its own benefit. In practice this will mean that the company taking out the loan must be able to point to tenders from other FSA/FCA regulated loan providers that are at a higher rate of interest. 

If these measures were enacted and implemented then most of the loan schemes used by companies like GSK and Wales and West Utilities would immediately become either unworkable or unprofitable. None of this requires new tax treaties with other countries (although it may require existing treaties to be shredded - no bad thing!) All that is required is political will, a bit of intelligence from our elected politicians, and a new tax law.

Tuesday, 16 April 2013

The Big Lie #2 (Part 2): Small Govt = Higher Growth

In my previous blog post I outlined some of my criticisms of the neoliberal stance against Big Government, and in particular the spurious arguments that are generally advanced in support of the concept of low taxes and the small state; arguments such as the Rahn curve. This is not to say that the Rahn curve is wrong per se. I doubt than many would argue that there should be no upper limit on government spending, or that politicians should always aim to make the public sector as large as possible. The real problems with the Rahn curve are twofold. 

Firstly, it implies that the only variable that matters in determining economic growth is the quantity of government spending, and not what the money is spent on, or other factors within the economy such as levels of investment (public and private), education, consumer demand or inequality. 

Secondly, it implies that there exists a single unique value for the ratio of government spending to GDP that is optimal for all countries irrespective of their size, their stage of economic development or their range of economic diversity. 

For example, there are many developing countries with smaller governments and much larger growth rates than the UK: China, Brazil, India for example. But even if all developing countries with smaller governments than the UK have larger growth rates, that does not mean the UK would increase its own growth rate by following suit and reducing the size of the State. These countries have higher growth-rates than the UK because they are playing catch-up. They don't have to "re-invent the wheel" because other countries have already done that for them. Their growth is not constrained by the limited demand of their own consumers because they can piggyback on the higher spending capacity of consumers in more developed countries. And their governments are small because the disposable income of their citizens is small and so their tax base is small. Therefore the economies of these countries contain no lessons from which we in the UK can learn. 

Instead much of the analysis tends to centre on comparisons between countries with advanced economies, particularly those in the OECD. Yet even here there is much subjectivity in the comparative analysis. 

For example, last year Martin Wolf of the Financial Times analysed the growth rates of the 18 most advanced OECD countries over the 22 year period from 1989 to 2011 and published them on his blog. The 16 OECD countries he ignored were: Chile, Czech Republic, Estonia, Greece, Hungary, Iceland, Israel, South Korea, Luxembourg, Mexico, Norway, Poland, Portugal, Slovak Republic, Slovenia and Turkey. 

The results (shown above) indicate that there is very little evidence that low tax economies yield higher growth rates. Martin Wolf's interpretation of the data was: 

 The first conclusion is that there is no relation between the share of government revenue and the rate of growth of real output per head (that is, productivity) over the 1989-2011 period. The “regression line” is flat. 

I disagree. If you discard the data points for Ireland and Spain for the reason that their growth over the period was artificially inflated by transfers from wealthier EU nations (Martin Wolf also discounts the Irish datum as being an "outlier"); and also those of Australia and Canada because they atypically have economies based on mining and agriculture rather than industry, banking and services (so their growth is not endogenous but is inflated by rises in commodity prices driven primarily by growth in China); then the data actually points to a positive correlation between Big Government and higher growth. The regression line through the remaining data points is linear and has a distinct upward slope. In fact the rise in growth rate is about one percentage point for every 28% of GDP spent by government. Not bad! Not bad at all in fact! 

Of course there are many other studies by right-wing economists and think tanks that claim to prove the opposite by selectively using different baskets of countries (often ones with wildly dissimilar economies and questionable political systems) or dubious statistical averages. The approach taken here by Ryan Bourne and Thomas Oechsle at the right-wing Tory/Thatcherite think tank, the Centre for Policy Studies (CPS) is a case in point and one that I find particularly dubious for reasons that I might discuss in a future blog post. 

One way to avoid the complication of comparing different countries is to stick to the same country but then compare its performance under different macroeconomic conditions. The history of economic growth in both the UK and the USA over the last 150 years is a good example. Over this period both countries experienced periods of small government (before 1929) and large government (after 1950). The neoliberals would have you believe that the earlier period, when government was small, was a period of dynamic and rapid growth, with the animal spirits of the entrepreneur freed from the later suffocating bureaucracy of the State. What rubbish!

The graph above illustrates the growth in real GDP per capita in the UK from 1850 to the year 2000 (green curve) together with the size of government (black curve). I have highlighted two distinct regions. The blue region is the period of small government where government spending was generally less than 15% of GDP (with a slightly higher blip during the 2nd Boer War). The pink region is the period of Big Government where government spending was generally above 35% of GDP. The period from 1915 to 1950 has been discarded from the analysis because the economy over this time period was dominated by war spending for the First and Second World Wars. Yet the contrast in GDP growth between the blue and pink periods is stark. 

Firstly, GDP growth was more unstable in the blue period than it was in the more recent pink period. There were more recessions and those recessions were deeper. The twenty year rolling average of GDP growth (as indicated by the red curve) also shows two distinct patterns of behaviour. This data is shown again on the graph below for greater clarity. 

Before 1940 the twenty year rolling average of GDP growth never rose above 1.3%. After 1950 it rarely fell below 1.5%. The average growth rate over the 65-year long blue period 1850-1915 was only 0.94% per annum. For the post-war pink period of 1950-2000 it was more than 2.2% per annum. These are striking differences! 

And yet they are not just confined to UK economic performance. Exactly the same trends are to be seen in the economic data of the USA over the same periods. 

When one looks at the economic data of the USA for the 25 years immediately prior to the 1929 crash one sees that US government spending averaged less than 10% of GDP. For the 25 years before that the average was even lower at barely 3% of GDP. In contrast, over the period 1950 to 2000 the average was closer to 35% of GDP. 

For the period 1879-1929 real GDP was 5.5 times larger in 1929 than it was fifty years earlier. That equates to an average annualized growth of 3.47%. Yet for the fifty years after 1950 the factor was 5.6 and so the growth was actually slightly higher at 3.50%pa. However this neglects the effects of population growth. 

Between 1880 and 1930 the US population grew by 150% whereas from 1950 to 2000 it only grew by 86%. So the annualized growth rates in real GDP per capita for the two periods are actually 1.6% and 2.2% respectively. Once again that is a big difference, particularly when continued over fifty years, although the difference is not as stark as in the UK. This difference over time can be seen in the plot of the 20-year rolling average of GDP growth in the graph below. 

However the benefits of higher public spending don’t end there. They are also seen in the volatility of the growth rate and the frequency and severity of the ensuing recessions, just as in the UK case. The striking thing about the GDP growth rate over the period 1879-1929 is its extreme volatility. One year growth could be over 10% and a couple of years later GDP is contracting by just as much. This happened repeatedly over that period. As a result the average growth rate was 3.6% but the standard deviation in this value was even greater at 5.2%. 

Contrast that with the second half of the twentieth century where the average growth rate was 3.5% but the standard deviation was actually much smaller at 2.3%. Not only that but this period also experienced recessions that were mild by historical standards with contractions in GDP of typically only 1%-2% each time. The period 1879-1929 on the other hand was blighted by repeated recessions where GDP contracted by 5%-10% or more. 

What this demonstrates is the stabilizing effect of high government spending (plus of course the added benefits of a Federal Reserve Bank and deposit insurance instead of a system of free banking which existed for most of the 19th Century). It is easy to see why. If government spending is high and generally fixed, then the capacity for the economy to contract during a recession is reduced. So recessions are less severe, less capital investment is lost due to business failures and so when the recovery begins less new capital investment is needed to replace what was lost in the recession. Thus the economy functions more efficiently with higher overall growth rates. 

Moreover, even in boom periods Big Government aids growth because it provides the private sector with guaranteed markets. That improves business confidence and therefore raises long-term investment. Not only that, but Big Government also increases the level of redistribution within the economy, thereby reducing inequality and raising aggregate demand, which also boosts investment confidence and growth. 

So for those still hankering after small government I suppose the BIG question is this. Which type of economy do you really want to live in? 

(i) An economy with more government that offers better public services, higher growth, fewer recessions, greater economic stability and security, less inequality and few if any depressions? 


(ii) An economy with inadequate small government that can only offer poor public services, low growth, more recessions, greater economic instability with little long-term security, more inequality and regular massive depressions? 

Wow! What a tough choice.

Sunday, 14 April 2013

The Big Lie #2: Small Govt = Higher Growth (Part 1)

Which is better for the economy: a large public sector or a small one?

This is a debate that has continued for decades but is now even more pertinent given the current government's zealous attack on public spending. For while "Slasher" Osborne and his colleagues may continue to claim publicly that their spending cuts are driven by a need to reduce the deficit, the reality is that for many in the coalition this course of action is driven more by ideology than economic reason. They are cutting the size of government because they want too, not because they believe they have to.

For many Thatcherites, neoliberals and old-fashioned Gladstonian Liberals, it is not just about the size of the current budget deficit, or even about the current budget deficit at all. It is about implementing measures that they believe will unleash a tsunami of entrepreneurial dynamism. In fact in both the Conservative Party and in the Liberal Democrats there exists a dominant strand of economic ideology that sees the move towards a small state as a necessary prerequisite for delivering higher levels of economic growth. Of course it is just a coincidence that reducing the size of the state necessarily involves reducing taxes, thereby allowing the rich to retain an even greater proportion of their wealth and income. 

At the heart of this debate is the Rahn curve. Like its paramour the Laffer curve which argues that there is an optimal tax rate that maximizes government tax revenues and is therefore used by neoliberals to justify tax cuts for the rich, the Rahn curve claims a similar relation between GDP growth and the size of the public sector. But there are other supposed justifications for a smaller state that are regularly wheeled out by the neoliberal Right. One is the concept of "crowding out" (the squeezing of supply to the private sector by excessive government demand), while the other comes from the various quotes of eminent historical economists (including some seen as being more on the left like John Maynard Keynes and Hyman Minsky) that "in their opinion optimal government spending should be less than 25%". 

Of course in the case of eminent opinion context is everything. Keynes may have believed that an economy with 25% of GDP under the control of the State was bordering on excessive, but at the time there was no NHS, and manufacturing, mining and agriculture accounted for over 50% of GDP. Now that these sectors account for less than 20% of GDP can we really cling to the same old certainties or prejudices? Of course not! 

A more realistic analysis would be to recognize that the size of the state is inextricably linked to the overall size of the services sector of which it is a major part. Thus as the relative size of production in the economy decreases, the size of services must increase and with it also the size of the State. Not only that, but as the means of production is concentrated into the hands of fewer and fewer workers, so the importance of the State will increase as a necessary means of redistributing the earnings from that production amongst the wider populace. Without it inequality would be greater, and as we are finding now, recessions would be deeper and more frequent. 

In the case of the Rahn curve the justification is based on a logic that is derived from the Laffer curve. Yet there is a fundamental difference between the two curves when it comes to the veracity of the theory that underpins their underlying reasoning. 

In the case of taxation and thus the Laffer curve, any level or rate of tax yields positive revenues for the government. But if the tax rate is zero, then the revenues collected must clearly be zero. However, if the tax rate is 100% then the revenues collected are also likely to be close to zero as there is no incentive for anyone to work, at least that is the theory (see below for a counter-argument). Thus in the case of the Laffer curve, the revenue curve must be zero when the tax rate is at either 0% or 100% and as the tax revenue must always be positive, the curve must be positive at all points in between. Therefore the curve must have a maximum somewhere in this region. The question that is continually being debated is, where exactly is that maximum? While the neoliberal Right claim it to be as low as possible (20% or less), there is a growing body of evidence to suggest it is much higher and may even be as high as 70%. 

The proponents of the Rahn curve try to make an identical argument for GDP growth. Unfortunately their logic is flawed. They try to claim that when there is no government (i.e. government spending is zero), growth must be zero, but there is no reason why this should be true. If as the neoliberals claim, it is the private sector and only the private sector that can deliver economic growth, then they cannot at the same time demand a residual of government spending to make it happen. All that is required for a functioning capitalist economy is a well-defined currency and the rule of law, not government spending. 

They also try to claim that when there is no private sector (i.e. government spending is 100% of GDP) growth must be zero again, but there is no reason why this should be true either. Even communist countries can have positive growth rates even if they are generally much lower. 

Nor is it the case that growth rates must always be positive for all intermediate sizes of government between the two limits described above. Unlike tax revenues, GDP growth is not restricted to positive quantities. 

Thus the Rahn curve is fundamentally flawed, but in truth so is the Laffer curve. As hinted at above, the upper tax limit of 100% will not discourage all work as the neoliberals claim. In practice most people will continue to work even when all their income is taken in tax as they know that the taxes they pay must be returned to them in the form of services and transfer payments, and thus the more they work the more that will be returned. So while a "nationalization of income" will reduce incentives to work harder, it will not completely remove them. Somewhat counter-intuitively, a tax rate of 100% is more likely to kill growth rather than government tax revenues as it removes the incentive for each individual to work harder than his neighbour. 

Of course the attempts to intellectually justify the drive for a smaller state do not come purely from Rahn curve analysis. There are other macroeconomic justifications, the primary one being the concept of "crowding out". 

The argument is that if the State hogs too much of the nation's resources, then this increases the demand for those resources and so increases their price. This then puts additional costs on the private sector which leads to reductions in growth. And the two resources for which the State has the greatest appetite are labour and capital. 

Thus if the State employs too many people, or too many of the most skilled people, then the cost of labour should increase. But if this happens we should see evidence of it in excessive growth in wages and subsequently in inflation and high interest rates. Yet for most of the past twenty years we have seen neither. 

Similarly, if the State absorbs too much capital through borrowing or taxing, the effects would be seen in the growing cost of borrowing for business. Again the last twenty years show little evidence of this. It is therefore difficult to justify any claim that crowding out has impeded growth over the last few decades. 

So much for the theory behind the Rahn curve and the principle of crowding out. As is we have seen, the curve itself has no mathematical integrity, while the economic data from the last two decades provides no substance to the claim that the State has been too big, or that it has had a detrimental impact on other economic indicators like wages, inflation and interest rates. But what about the comparative evidence with other similar economies, or for economies with different levels of government spending? 

In my next post I will show that contrary to the claims of the neoliberal Right, both the USA and the UK have experienced higher growth-rates in the post-war period where their government spending exceeded 25% than they did in earlier periods where government spending was much less than 25%. Not only that, but the increase in government size has contributed to greater economic stability and fewer recessions. In short: Big Govt. = Higher Growth!